By Dirk J.J. Suringa, Esq. Covington & Burling LLP, Washington, DC
The Tax Extenders Act of 2009 (TEA),1 passed by the House of Representatives on December 9, 2009, included a revised version of the Foreign Account Tax Compliance Act (FATCA), first introduced in the House Ways and Means Committee and the Senate Finance Committee on October 27, 2009. TEA refined and improved many aspects of the original version of FATCA, but a "TEA Party" for the legislation is still unlikely due to certain policy concerns that remain unaddressed.
FATCA combined several proposals in the Obama Administration's FY 2010 Budget,2 the Stop Tax Haven Abuse Act,3 and the offshore compliance bill drafted by the Senate Finance Committee.4 The goal of FATCA, like those prior proposals, is to discourage U.S. taxpayers from evading U.S. income taxation by hiding assets outside the United States and not reporting the income thereon. This is demonstrably a worthwhile goal. The revenue losses associated with offshore tax evasion are significant.5 Large scale tax evasion undermines the public's sense of equity in the U.S. tax system and unfairly shifts the cost of public services to law-abiding taxpayers. FATCA attempts to accomplish its enforcement goal primarily by creating several new information-reporting requirements and imposing withholding-tax, financial, and other penalties for the failure to file the required reports. While the overall approach of requiring increased disclosure is correct, the original version of FATCA had its share of technical and other problems, some of which have been pointed out elsewhere.6
In response to initial feedback, the second iteration of FATCA, Title V of TEA, improved upon the original in several respects.
First, the revised version of FATCA gives taxpayers and foreign financial institutions more time to prepare for its implementation. The original effective date for the 30% withholding tax on payments to foreign financial institutions ("FFIs") that fail to enter into an agreement with the IRS, or for non-FFI foreign entities that do not produce the new U.S. ownership certificates, was for payments made after December 31, 2010.7 It was not realistic to expect that the IRS within one year could develop guidance and enter into agreements with all FFIs that receive payments related to U.S.-source ordinary income and capital gains taxable under FATCA, much less that FFIs would be able to implement the required systems changes to accommodate the new regime. The updated effective date is a much more realistic "payments made after December 31, 2012."8
Second, the TEA version of FATCA allows FFIs to agree to withhold on depositors that do not want to provide identifying information (so-called "recalcitrant account holders").9 Under the original version of FATCA, such FFIs would have had to choose between closing the accounts of such customers or failing to reach the agreement with the IRS that is required to avoid the 30% withholding tax. This provision is a good idea, but it may be tricky to implement and oversee. One way the IRS has tried to apply U.S. taxation requirements extraterritorially is the closing agreement foreign insurance companies are required to sign with the IRS to obtain the benefit of certain treaty exemptions for the federal excise tax on insurance premiums.10 In that situation, however, there is an underlying treaty relationship, and thus information exchange, that will be absent in the case of many FFIs making the election under TEA.
Third, TEA eliminated the "material advisor" reporting provision. As originally drafted, FATCA would have required an information return to be filed by so-called "material advisors" who earn more than $100,000 in any year from assisting in the direct or indirect creation or acquisition of an interest in a foreign entity with respect to which certain U.S. information returns (e.g., Form 5471) must be filed.11 The provision as drafted appeared to be both over-inclusive and under-inclusive. On the one hand, the provision on its face would have required reporting with respect to all types of services (e.g., IT consulting services), all types of persons (e.g., in-house lawyers in the M&A department), and all types of direct or indirect "interests" in the foreign entity (e.g., any public debt offering of the U.S. parent of an affiliated group that indirectly owns CFCs). The enforcement value of such broad information is unclear. On the other hand, the provision arguably would not have reached low-level enablers who might well charge less than $100,000 for setting up sham foreign entities with phony accounts.
Fourth, TEA narrowed the new passive foreign investment company (PFIC) reporting provision in the original version of FATCA. FATCA would have required any shareholder of a PFIC to file an information return regarding the PFIC.12 Section 1297 defines a PFIC based solely on its assets and income, not based on whether it has any U.S. shareholders.13 Thus, FATCA technically would have required foreign shareholders of a PFIC with no U.S. ownership or any other relevance to the U.S. tax system to file an information return with the IRS.14 TEA fixed this issue by narrowing the reporting requirement to "U.S. persons," and gave the IRS explicit regulatory authority to limit the scope of the provision. Nevertheless, the revised provision still suffers from the practical problem that a U.S. person with a fractional stock ownership interest in a PFIC could be required to report corporate information to which he or she has no access.
Fifth, TEA softened the blow from FATCA's repeal of the foreign-targeting exceptions to the TEFRA sanctions on bearer bonds.15 One of those sanctions is an excise tax on bearer bonds, and the language of the statute could be read to apply the tax extraterritorially.16 By repealing the foreign-targeting exceptions to the excise tax, old FATCA might have been read the excise tax to foreign bearer bond issuances with no connection to the U.S. tax system.17 TEA eliminates this implication.18 TEA also provides that a book entry system includes a dematerialized book entry system, which clarifies current law and will help to avoid the unintentional application of the remaining TEFRA sanctions in foreign markets that do not use traditional book-entry registration systems.19
Sixth, TEA revised FATCA to resolve several issues affecting the U.S. possessions. Under FATCA as originally introduced, banks formed in the possessions were treated as FFIs, but most possessions residents are U.S. citizens. Thus, for example, old FATCA could have required a Puerto Rican bank to report all of its Puerto Rican depositors to the IRS, when in most cases those depositors have no U.S. tax liability, only a possession tax liability.20 The TEA resolved this and other issues affecting the possessions.21
TEA thus improved on the technical details of FATCA. Nevertheless, certain overall problems remain with its unilateralist approach to information reporting. First, the sanction that FATCA uses to force foreign entities to disclose U.S. ownership information is a U.S. withholding tax that the foreign entity can avoid simply by refusing to invest in the United States. It is somewhat counterintuitive to allow tax cheats and their enablers to continue to evade U.S. taxation provided they sell their U.S. assets and invest exclusively in capital markets that compete with ours. Second, TEA makes explicit that FATCA is intended to override U.S. tax treaties.22 Most U.S. tax treaties do not condition treaty benefits on the absence (or disclosure) of U.S. ownership interests. For example, a foreign corporation could qualify for benefits under the active trade or business test without disclosing whether it has U.S. owners. When TEA becomes effective, it would appear to require disclosure or separately impose a 30% withholding tax. Treaty overrides adversely affect the treaty-making process and historically have been avoided unless absolutely necessary. As discussed below, they may not be in this case. Third, FATCA may invite retaliation against U.S. financial institutions and companies, which could be singled out and subjected to competing information reporting requirements from foreign jurisdictions.
Each of these problems could be mitigated if the United States were to persuade at least a few of its major trading partners to adopt their own regime similar to FATCA. This approach would change the dynamic for FFIs on the fence about whether simply to divest from the United States, and it would potentially smooth over some of the disruptive effects of a treaty override and discourage retaliation. With the 2013 effective date TEA has given Treasury, there should be time to see whether a multilateral approach can work.
1 H.R. 4213, 111th Cong. (2009).
2 Department of the Treasury, General Explanations of the Administration's Fiscal Year 2010 Revenue Proposals, at 41-46, 54-57 (May 2009).
3 S. 506, H.R. 1265, 111th Cong. (2009).
4 Committee on Finance Discussion Draft S. __, 111th Congress (2009) ("Discussion Draft"), available at http://finance.senate.gov/press/Bpress/2009press/prb031209c.pdf.
5 According to Internal Revenue Service estimates, the "tax gap" for the 2001 taxable year was $345 billion. Internal Revenue Service, IRS Updates Tax Gap Estimates, IR-2006-28 (Feb. 14, 2006). Part of this tax gap is attributable to tax evasion by individuals. Id.
6 For prior coverage of FATCA, see Tanenbaum, "More International Tax Enforcement: Leading with the Foreign Account Tax Compliance Act of 2009," 38 Tax Mgmt. Int'l J. 702 (Dec. 2009).
7 S. 1934, H.R. 3933, 111th Cong. §101(d)(1) (2009).
8 H.R. 4213, §501(d)(1).
9Id. §501(a) (proposed §1471(b)(1)(D)).
10Seegenerally §4371; Rev. Proc. 2003-78, 2003-2 C.B. 1029.
11 S. 1934, §301(a) (proposed §6116).
12Id. §302(a) (proposed §1298(f)).
14 Under FATCA, the sanction for the failure to file a PFIC report is an extended statute of limitations. S. 1934, §203. Under the prior version of FATCA, this would have been of little significance to foreign persons with no return filing obligation unless they (or their spouse, in community property jurisdictions) were to become a U.S. citizen or resident. At that point, the extended statute of limitations would have applied retroactively to extend their statute of limitations indefinitely until the required information returns were filed. TEA appears to have corrected this problem by narrowing the category of taxpayers required to report.
15 §§163(f)(2)(B) (issuer's interest deduction), 871(h)(2) (portfolio interest exemption), 4701(b)(2) (excise tax).
17 S. 1934, §102(a).
18 H.R. 4213, §502(e).
19Id. §502(c); see also Notice 2006-99, 2006-2 C.B. 907.
20See, e.g., §933(1) (exempting Puerto Rican-source income from U.S. taxation in the case of a bona fide resident of Puerto Rico).
21 H.R. 4213, §501(a) (proposed §171(d)(4)); see also id. (proposed §1472(c)(1)(C)); id. §511 (proposed §6038D(h)). However, TEA did not definitively resolve the treatment of PFICs formed in the possessions and owned by possessions residents. Under Prop. Regs. §1.1291-1(f), those shareholders are in most cases exempt from U.S. taxation with respect to their PFIC interests, but they still could be required to report information under TEA's version of §1298(f).
22 H.R. 4213, §501(a) (proposed §1474(b)(3)).This commentary also will appear in the February 2010 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Tello, 915 T.M., U.S. Withholding and Reporting Requirements for Payments of U.S. Source Income to Foreign Persons, and in Tax Practice Series, see ¶7150, Withholding and Compliance.