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In a prior commentary, I briefly summarized then-current legislative and administrative proposals to strengthen and extend the IRS's "qualified intermediary" (QI) program in an attempt to address tax evasion by U.S. individuals hiding behind foreign corporate shells. (See "On Various Proposals to Strengthen and Extend the QI Regime, Part One: Redefining the QI's Role," 38 Tax Mgmt. Int'l J. 716 (11/13/09).) That installment noted that the QI rules were ill-suited to the task being required of them, for three reasons:
• Nothing in the QI rules prevents a U.S. person from creating a foreign corporation to open an offshore account;
• The current 30% U.S. withholding tax is not a deterrent to U.S. persons that invest through a foreign corporation; and
• The QI regime applies only to U.S.-source income.
The prior installment further concluded that if the QI rules were made too onerous, financial institutions might be driven away from the QI system. To prevent this from happening, the proposals that were addressed in that installment all sought to add sticks to the carrot of the QI regime, hoping to ensure that U.S. tax dodgers do not resort to non-qualified intermediaries (NQIs) and to encourage covered entities to become QIs.
After the prior installment was published, the proposals under discussion were upstaged by the introduction of a new bill, filed in both the House and the Senate, entitled the Foreign Account Tax Compliance Act of 2009 (FATCA). FATCA addresses the shortcomings of the QI regime noted above by ignoring the QI regime entirely and layering on top of it a new set of information gathering and reporting rules. This installment will undertake a high-level comparison of the approaches taken in the prior proposals, including the Administration's "Green Book" proposal, with the approach taken in FATCA.
The prior proposals divided the world into two broad categories – QIs and NQIs. This approach proved cumbersome, because there are in turn at least two broad categories of NQIs. One category consists of financial institutions, such as foreign banks, that are not enrolled in the QI system but in theory could be. In some cases such NQIs lack QI status because they reside in countries that do not have know-your-customer (KYC) rules, making them ineligible to participate in the QI regime. In other cases the institution in question may simply have opted not to participate in the QI regime. A second category of NQIs includes entities that are not financial institutions as such, but are pooled funds or other investment vehicles often referred to as financial intermediaries. 1 In some cases these types of entities may be pass-through entities such as partnerships; in other cases they may be corporations. These types of intermediaries are generally not subject to local KYC regulations.
FATCA instead divides the world into "foreign financial institutions" covered by a proposed new §1471 of the Code and "non-financial foreign entities" governed by a new §1472. FATCA would include within the §1471 category many types of foreign entities that are not, and could not become, QIs. Specifically, foreign financial institutions would include deposit takers and custodians traditionally thought of as banks, as well as a broadly defined category of investment vehicles that would include private equity funds, hedge funds, and structured finance vehicles, such as CDOs.
Both the Administration proposal and FATCA would impose new withholding taxes on payments by U.S. withholding agents to noncompliant foreign persons. 2 In general, withholding agents would be required to withhold a 30% tax on payments of U.S.-source income to foreign financial institutions that fail to satisfy certain reporting and disclosure criteria and to other foreign entities that fail to establish who their beneficial owners are. 3
Foreign Financial Institutions
Probably the most important difference between FATCA and the prior proposals is that FATCA would apply the same information-gathering and reporting rules to all varieties of foreign financial institutions, whether QIs or NQIs, and whether subject to local KYC regimes or not. Under FATCA, the new withholding taxes applicable to foreign financial institutions could be avoided only by entering into a comprehensive reporting agreement with the IRS that looks much like an expanded QI agreement. Although the application of the prior proposals to many types of NQIs was less than perfectly clear, those proposals seemed to contemplate something like a "QI light" reporting regime that accorded some recognition to the very real differences in the reporting and recordkeeping capabilities of banks as opposed to other sorts of intermediaries (such as foreign mutual funds).
In particular, private equity funds and other entities organized as partnerships would need to develop far-reaching new procedures to comply with FATCA's rules and thereby avoid the new withholding taxes. Under current law, such funds can avoid withholding by becoming a "withholding foreign partnership." Such an entity is treated much like a QI, even though it is not a financial institution subject to KYC rules. For a number of reasons, qualification as a withholding foreign partnership is not common. 4 Alternatively, a foreign pass-through can avoid withholding by providing the withholding agent with a Form W-8IMY to which is attached Forms W-8 (or W-9) for each of its partners or owners, with Forms W-8 being passed down the chain. Even these procedures are cumbersome and error-prone, largely due to the fact that many funds are owned by large numbers of investors, many of whom may themselves be funds. But the stakes are much lower under current law, as the proceeds of securities sales are not subject to U.S. withholding tax.
It is doubtful that many types of entities classified as foreign financial institutions under FATCA would be willing and/or able to obtain the kind of information sought by this legislation, especially up through complex (and often overlapping) chains of fund ownership. Moreover, as noted, many of these entities are not subject to KYC rules and have not historically collected the type of information that the new rules would require.
Other Foreign Payees
Under both FATCA and the prior proposals, foreign payees that are not financial institutions would be subject to withholding unless they certified to the payor the extent to which they were owned by substantial U.S. owners. Foreign payees could also be required to report U.S.-owner identifying information to the IRS. The sweep of this proposal is breathtaking: it assumes that every foreign payee in the world, apart from those that may be exempted under regulation, is a screen behind which taxable U.S. persons are hiding. In order to be exempt from the 30% withholding tax, nearly every foreign entity deriving U.S.-source income would have to determine whether it has substantial U.S. owners.
FATCA and the other proposals deliberately employ an overbroad withholding tax on U.S.-source income to flush out ownership information as a proxy for the fact that the United States has no power to require foreign persons to withhold on non-U.S. income payable to U.S. persons. That is, the stick being crafted here is a very blunt instrument. Government spokespersons have said that they do not intend to collect significant revenue from these new withholding taxes because, if the rules work as designed, all foreign payees will come into compliance and no withholding taxes will be imposed. The revenue estimates for this legislation are thus supposedly premised on the identification and capture primarily of previously unreported non-U.S.-source income of U.S. taxpayers.
Perhaps for this reason, the proposals are very sketchy about how refunds would be obtained in the event of over-withholding, particularly under treaties. If the refund procedures do not work well, many foreign persons who determine that it is too burdensome (or in some cases even impossible) to comply with the new rules will very likely cease to invest in the United States. This would not only affect the U.S. economy in ways difficult to predict, it would also be counterproductive from a tax perspective, because U.S. persons will continue to be able to avoid detection with respect to their non-U.S. income.
FATCA may also have the effect of discouraging true foreign financial institutions from becoming QIs, and may encourage many to shed their QI status. Because FATCA imposes rules that apply in addition to the QI rules, and gives no special benefits to QIs, foreign banks and other potential QIs may determine that the remaining benefits of QI status are not worth the additional burdens being imposed on them. If this occurs, the United States will lose the one proven handle it had on collecting reports implicating U.S. investors offshore.
All of these proposals seek to negotiate a very delicate balancing act. Any country that wishes to tax its residents on their worldwide income faces two basic methods of doing so. It can withhold on all payments of domestic-source income and require those eligible for relief (e.g., residents of treaty countries) to apply for refunds. This is the model used in many developing countries, which are less focused on inbound investment than on outbound expatriation. Or it can exempt most payments to foreign persons based on adequate documentation. The problems with the first approach are obvious – it discourages inbound investment into a country's capital markets, and does nothing to ensure that residents pay tax on foreign-source income. This fact alone explains why the United States has traditionally chosen the second alternative.
The U.S. QI regime, as currently constituted, represents a rational compromise between these competing imperatives. It is designed to enable inbound flows of capital with minimum over-withholding, while at the same time relying on the self-interest of financial intermediaries to police entitlement to treaty benefits. What it does not do as well is police cheating by U.S. taxpayers. In order to get at U.S. taxpayers, both the Administration proposal and FATCA would tilt the balance in favor of a withholding regime that shoots first and asks questions later. Regardless of any regulations easing the rules, the inevitable result will be a climate more hostile to legitimate inbound investment. Under these proposals, the United States would move toward an insular developing country model.
This commentary also will appear in the January 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 for Payments of U.S. Source Income to Foreign Persons, and Cole, Kawano and Schlaman, 940 T.M., U.S. Income Tax Treaties — U.S. Competent Authority Functions and Procedures, and in Tax Practice Series, see ¶7140, U.S. Income Tax Treaties and ¶7150, Withholding and Compliance.
1 There are other types of intermediaries that are not financial institutions, such as agents. These will not be covered here. For a good discussion of the problems they would face under the new proposals, see Letter from IRPAC to Commissioner Shulman, dated June 25, 2009, BNA Daily Tax Rpt. (7/8/09).
4 Because a withholding foreign partnership must be able to determine the percentage of its income allocable to its partners at the time it receives an item of U.S.-source income, partnerships having other than "straight up" allocations cannot easily qualify to become withholding foreign partnerships.
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