Analysis of FATCA Proposed Regulations

Douglas S. Stransky and Martha F. Coultrap of Sullivan & Worcester LLP

On February 8, 2012, the Treasury Department and the Internal Revenue Service issued proposed regulations for the next major phase of implementing the Foreign Account Tax Compliance Act (FATCA). The regulations lay out a step-by-step process for U.S. account identification, information reporting, and withholding requirements for foreign financial institutions (FFIs), certain non-financial foreign entities (NFFEs) and U.S. withholding agents.

FATCA was enacted in 2010 by Congress as part of the Hiring Incentives to Restore Employment (HIRE) Act. FATCA generally requires FFIs to report to the IRS information about financial accounts held by U.S. taxpayers or by NFFEs in which U.S. taxpayers hold a substantial ownership interest.

FATCA imposes a 30 percent withholding tax on certain U.S. source payments to FFIs and NFFEs that fail to comply with their information reporting obligations. To avoid having tax withheld on such payments under FATCA, an FFI will have to become a participating FFI by entering into an agreement with the IRS prior to June 30, 2013 that the FFI will:

  • Identify U.S. accounts or interest holders;
  • Report certain information to the IRS regarding such U.S. accounts or interest holders;
  • Verify its compliance with its obligations under the agreement; and
  • Ensure that a 30 percent tax on certain payments of U.S. source income is withheld when paid to non- participating FFIs and account holders who are unwilling to provide the required information.

Since FATCA's enactment and prior to the issuance of the proposed regulations, the IRS has issued preliminary guidance on the implementation of FATCA. See Notice 2010-60, 2010-37 I.R.B. 329, Notice 2011-34, 2011-19 I.R.B. 765, and Notice 2011-53, 2011-32 I.R.B. 124 (FATCA Notices).

This article highlights the significant modifications and additions to the guidance in the FATCA Notices that is provided by the proposed regulations. The proposed regulations are expected to become final during the summer of 2012.

FATCA Overview and FATCA Notices

FATCA requires any withholding agent to withhold 30 percent on the following payments to an FFI:

  • any payment of U.S. source interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income (FDAP income); and
  • any gross proceeds from the sale or other disposition of any property of a type that can produce interest or dividends from sources within the United States.

FFI Requirements

An FFI can avoid the withholding tax, if the FFI either (a) enters into an agreement (FFI Agreement) with the IRS to perform certain obligations or (b) meets requirements prescribed by the IRS to be deemed to comply with the requirements of FATCA. An FFI is defined as a financial institution that (i) accepts deposits in the ordinary course of a banking or similar business; (ii) as a substantial portion of its business, holds 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, in addition to banks and traditional financial institutions, an offshore private equity fund having U.S. investors will be an FFI.

FATCA requires an FFI that enters into an FFI Agreement (participating FFI) to identify any depository account, any custodial account, and any equity or debt interest in it held by U.S. persons (U.S. account) or U.S.-owned foreign entities and comply with certain verification and due diligence procedures.

A participating FFI is required to report certain information on an annual basis to the IRS with respect to each U.S. account and to comply with requests for additional information with respect to any U.S. account. The information that must be reported includes: (i) the name, address, and taxpayer identifying number (TIN) of each account holder who is a U.S. person (or, in the case of an account holder that is a U.S.-owned foreign entity, the name, address, and TIN of each U.S. person that is a substantial U.S. owner of such entity); (ii) the account number; (iii) the account balance or value as of the last day of the reporting period; and (iv) the gross receipts and gross withdrawals or payments from the account for the reporting period.

If foreign law would prevent the FFI from reporting the required information, absent a waiver from the account holder or failure of the account holder to provide a waiver within a reasonable period of time, the FFI is required to "close" the account. The implications for an FFI that is a private equity fund are not clear, and whether such an FFI can fulfill its obligations under the FFI Agreement to close an account by withholding all distributions to the non-compliant account holder, has yet to be determined.

FATCA requires a participating FFI to withhold 30 percent of any passthru payment to a "recalcitrant" account holder who will not provide the required information or to an FFI that does not meet certain requirements (nonparticipating FFI). A recalcitrant account holder is any account holder that fails to provide the information required to determine whether the account is a U.S. account, or the information required to be reported by the FFI, or that fails to provide a waiver of a foreign law that would prevent reporting. A participating FFI may elect to withhold on passthru payments, and instead be subject to withholding on payments it receives, to the extent those payments are allocable to recalcitrant account holders or nonparticipating equity or debt holders FFIs.

NFFE Requirements

FATCA requires a withholding agent to withhold 30 percent of any withholdable payment to any NFFE, a foreign entity that is not a financial institution, if the payment is beneficially owned by the NFFE or another NFFE.

An NFFE can meet FATCA's requirements if: (i) The beneficial owner or payee provides the withholding agent with either a certification that such beneficial owner does not have any substantial U.S. owners, or the name, address, and TIN of each substantial U.S. owner; (ii) the withholding agent does not know or have reason to know that any information provided by the beneficial owner or payee is incorrect; and (iii) the withholding agent reports the information which has been provided by the beneficial owner or payee to the IRS.

Withholding Agents Liable for Tax

FATCA provides that every person required to withhold and deduct any tax under FATCA is made liable for such tax and is indemnified against the claims and demands of any person for the amount of any payments made in accordance with FATCA. In general, the beneficial owner of a payment is entitled to a refund for any overpayment of tax actually due under other provisions of the Code. However, with respect to any tax properly deducted and withheld under FATCA from a payment beneficially owned by an FFI, FATCA provides that the FFI is not entitled to a credit or refund, except to the extent required by a treaty obligation of the United States. In addition, no credit or refund shall be allowed or paid with respect to any tax properly deducted and withheld unless the beneficial owner of the payment provides the IRS with information to determine whether such beneficial owner is a U.S.-owned foreign entity and the identity of any substantial U.S. owners of such entity.

The Proposed Regulations

The proposed regulations seek to implement the FATCA reporting and withholding regime efficiently and effectively by establishing adequate lead times to allow system development and by minimizing the overall compliance burdens. The proposed regulations also provide guidance on topics that were not addressed in the FATCA Notices.

Modifications and Additions to FATCA Notices

Significant modifications and additions to the guidance in the FATCA Notices include the following:

Refinement of the Definition of Financial Account

FATCA defines a financial account to mean, any depository account, any custodial account, and any equity or debt interest in an FFI, other than interests that are regularly traded on an established securities market. The proposed regulations refine the definition of financial accounts to focus on traditional bank, brokerage, money market accounts, and interests in investment vehicles, and to exclude most debt and equity securities issued by banks and brokerage firms, subject to an anti-abuse rule.

Expanded Scope of "Grandfathered Obligations"

FATCA provides that no amount shall be required to be deducted or withheld from any payment under any obligation outstanding on March 18, 2012, or from the gross proceeds from any disposition of such an obligation. The proposed regulations extend that deadline to any payment made under an obligation outstanding on January 1, 2013, and any gross proceeds from the disposition of such an obligation.

Transitional Rules for Affiliates with Legal Prohibitions on Compliance

FATCA provides that the requirements of the FFI Agreement shall apply to the U.S. accounts of the participating FFI and to the U.S. accounts of each other FFI that is a member of the same expanded affiliated group. Recognizing that some jurisdictions have laws that prohibit an FFI's compliance with certain of FATCA's requirements, the proposed regulations provide until January 1, 2016 for the full implementation of FATCA.

Additional Categories of Deemed-Compliant FFIs

FATCA provides that an FFI may be deemed to comply with the law's requirements under certain circumstances. Notice 2011-34 provides initial guidance regarding certain categories of FFIs that will be deemed to comply with the FATCA requirements. The proposed regulations provide additional categories of deemed-compliant institutions to include: certain local banks, collective investment funds (under very limited circumstances) and affiliates of participating FFIs that register with the IRS and satisfy various requirements.

Modification of Due Diligence Procedures for the Identification of Accounts

FATCA requires participating FFIs to identify their U.S. accounts. Notices 2010-60 and 2011-34 provide guidance regarding the due diligence procedures that participating FFIs will be required to undertake to identify their U.S. accounts. To reduce the administrative burden on FFIs, the proposed regulations provide that FFIs may rely primarily on electronic reviews of pre-existing accounts. For preexisting individual accounts, manual review of paper records is limited to accounts with a balance or value that generally exceeds $1,000,000. Additionally, preexisting, individual accounts with a balance or value of $50,000 or less, and certain cash value insurance contracts with a value of $250,000 or less, are excluded from the due diligence requirement.

With respect to pre-existing entity accounts, the proposed regulations exclude accounts of $250,000 or less and extend reliance on information gathered in the context of the due diligence required to comply with anti- money laundering/"know your customer" (AML/KYC) rules, and simplified procedures to identify the status of preexisting entity accounts. With respect to new accounts, the proposed due diligence rules permit reliance by an FFI on its existing customer intake procedures.

Guidance on Procedures Required to Verify Compliance

FATCA requires a participating FFI to comply with certain verification procedures to identify U.S. accounts. The proposed regulations modify and supplement the prior guidance by providing that responsible FFI officers will be expected to certify that the FFI has complied with the terms of the FFI Agreement. Verification of such compliance through third-party audits is not mandated. If an FFI complies with the obligations set forth in its FFI Agreement, it will not be held strictly liable for inadvertent failure to identify a U.S. account.

Extension of the Transition Period for the Scope of Information Reporting

Notice 2011-53 provides for phased implementation of the reporting required under FATCA. Pursuant to Notice 2011-53, only identifying information (name, address, TIN, and account number) and account balance or value of U.S. accounts would be required to be reported in 2014 (with respect to the 2013 year). The proposed regulations provide that reporting on income will be phased in beginning in 2016 (with respect to the 2015 year), and reporting on gross proceeds will begin in 2017 (with respect to the 2016 year).

Passthru Payments

FATCA requires participating FFIs to withhold on passthru payments made to nonparticipating FFIs and recalcitrant account holders. Notice 2011-53 states that participating FFIs will not be obligated to withhold on passthru payments that are not withholdable payments (foreign passthru payments) made before January 1, 2015. The proposed regulations provide that withholding will not be required with respect to foreign passthru payments before January 1, 2017; instead, the proposed regulations require participating FFIs to report annually to the IRS the aggregate amount of certain payments made to each nonparticipating FFI.

In the case of jurisdictions that enter into agreements to facilitate FATCA implementation, the IRS will work with the governments of such jurisdictions to develop practical alternative approaches to achieving the policy objectives of passthru payment withholding. In addition, where such an agreement provides for the foreign government to report to the IRS information regarding U.S. accounts and recalcitrant account holders, FFIs in such jurisdictions may not be required to withhold on any foreign pass thru payments to recalcitrant account holders.

This article was first published in Practical International Tax Strategies, March 31, 2012.

Douglas S. Stransky, Partner,

Mr. Stransky is an International Tax Partner in Sullivan & Worcester LLP's Boston office and a lecturer at law with the Boston University Law School Graduate Tax Program. He is a member of the Advisory Board of Practical Tax Strategies.

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Martha F. Coultrap, Partner,

Ms. Coultrap is a Corporate Partner in Sullivan & Worcester New York Office and head of the Private Investment Funds and Institutional Investors Practice Group.

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Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Douglas S. Stransky. © 2012 Sullivan & Worcester LLP. This work reflects the law at the time of writing March, 2012.