Jeffrey R. Davine and Wayne R. Strasbaugh
Ballard Spahr LLP, Denver, CO and Philadelphia, PA
A package of provisions on international finance reporting labeled as the Foreign Account Tax Compliance Act (FATCA) are included in the Hiring Incentives to Restore Employment Act (HIRE Act), the jobs bill signed by President Obama on March 18, 2010. Tax-withholding provisions slated to come generally into effect after December 31, 2012, may have substantial ramifications for foreign investment in the United States.
U.S. citizens and residents are taxed on their worldwide income, but only U.S. payors report income (typically on Forms 1099) to the IRS. The FATCA provisions aim to force foreign financial institutions (FFIs)—broadly defined to include not only banks but such investment vehicles as offshore hedge funds and private equity funds—to report foreign-source income earned by U.S. taxpayers that might otherwise go unreported.
FATCA does this by requiring any U.S. payor to withhold and pay over to the IRS 30% of any U.S.-sourced payment of interest, dividends, rents, salaries, wages, premiums, annuities, or similar income items (FDAP, for fixed, determinable, annual, or periodic payments) that is not attributable to the conduct of a trade or business within the United States. Withholding also applies with respect to the gross proceeds from the sale or disposition of any type of property (such as stocks and bonds) that can produce U.S.-source interest or dividends (even if there is no gain on the disposition).
Avoiding the Withholding Through IRS Agreement
Though generally refundable, this punitive level of withholding is designed to compel an FFI to collect information about its clients and investors for IRS benefit. It can be avoided only if an FFI payee has entered into an agreement with the IRS holding that:
The FFI must obtain information from its account holders in order to identify the U.S. accounts—those held by any U.S. citizen or resident (in excess of $50,000 after aggregating the accounts that person holds with the FFI), domestic corporation or partnership, or a U.S. trust or estate. Also included is any account held by a foreign entity with a "substantial United States owner," defined as owning more than 10% of a corporation's stock (by vote or value) or of a partnership's capital or profits interests, or—in the case of any organization engaged primarily in the business of investing in or trading in securities, partnership interests, or commodities—any U.S. owner.
The FFI must comply with verification and due diligence procedures specified by the IRS regarding the identification of U.S. accounts.
For each U.S. account, the FFI must report annually certain information, including the name, address, and taxpayer identification number of each U.S. person; the account number and account balance and, to the extent provided by the Secretary of Treasury, the gross receipts and gross withdrawals or payments from the account.
The FFI must deduct and withhold 30% of any payment it makes to a "recalcitrant account holder" or to another FFI that does not have a similar agreement with the IRS (a "noncompliant FFI"). A "recalcitrant account holder" is a holder that does not provide information enabling the FFI to determine whether the account is a U.S. account or a holder that fails to waive foreign privacy or confidentiality laws that prevent the FFI from reporting account information to the IRS.
The FFI must comply with Treasury requests for additional information regarding any U.S. account it maintains.
If reporting or disclosing any information is prohibited under foreign law, the FFI must attempt to obtain a valid and effective waiver of the privacy law from the account holder allowing disclosure of any information required by FATCA. If a waiver cannot be obtained, the FFI must close the account.
It is not clear what procedures will be in place so that the withholding agents will know whether an FFI has entered into the appropriate agreement or is exempt from the withholding requirements. Coordination of the new agreements with the existing Qualified Intermediary (QI) program is also not specified. Presumably, these details will be clarified in regulations or other pronouncements before the effective date.
Bypassing an IRS Agreement
An FFI can avoid entering into the agreement with the IRS if it complies with procedures prescribed by the IRS to ensure that it does not maintain any U.S. accounts and with any other IRS requirements regarding accounts the FFI maintains with other FFIs. The IRS may also exempt certain FFIs as a class if it determines that FATCA's information reporting goals are satisfied through other means. This exemption may, for example, be available to institutions in countries that already share information with the IRS.
An FFI may shift its withholding obligations regarding recalcitrant account holders or non-compliant FFIs by electing to have the person making the payment withhold instead. To make this election, the FFI must notify each person (the withholding agent) making payments to it and provide the withholding agent with the information needed to determine the amount required to be deducted and withheld. The electing FFI must also waive any treaty rights the institution has to a lower withholding rate.
In lieu of reporting the account balance or value and the gross receipts and gross withdrawals from the account, an FFI may elect to report information about payments made to the account on regular IRS Forms 1099 as if the account holder were a U.S. individual. However, this alternative requires the FFI to report all payments and gross proceeds with respect to the account, not merely those that are U.S.-source.
Certain payments are excepted from the withholding provisions, including those to any foreign government or political subdivision; an international organization, agency, or instrumentality; a foreign central bank; or other persons determined by the IRS to pose a low risk of tax evasion.
Application to Other Foreign Payees
The FATCA provisions also apply to FDAP and gross proceeds paid by U.S. persons to non-financial foreign entities. With certain exceptions, a non-financial foreign entity is any foreign entity that is not a financial institution. In order to avoid the 30% withholding on all payments of FDAP and gross proceeds made to it by U.S. persons, a non-financial foreign entity must satisfy certain requirements:
The non-financial foreign entity must either (i) provide the U.S. payor (the withholding agent) with a certification that the beneficial owner does not have any "substantial United States owners" (as defined above), or (ii) provide to the withholding agent the name, address, and taxpayer identification number of each substantial U.S. owner.
The withholding agent must not know or have reason to know that any of the information provided is incorrect.
The withholding agent must report the information to the IRS.
FATCA withholding does not apply to payments made to non-financial foreign entities that are regularly traded corporations (or their affiliates), foreign governments, international organizations, foreign central banks, certain entities organized in U.S. possessions, and other categories that may be exempted by the IRS.
Withholding Tax Liability
A withholding agent (that is, a U.S. payor to a foreign person) is personally liable for failure to make the withholding tax payment and will be indemnified by the U.S. government against any payee claims for the amounts withheld.
Generally, taxes withheld under FATCA are subject to normal refund procedures where there has been an overpayment of tax by the beneficial owner of the payment. However, where tax has been withheld from a payment for which an FFI is the beneficial owner, no refund will be paid to the FFI unless the FFI discloses whether any of its beneficial owners are U.S. persons or U.S.-owned foreign entities, and no interest will be paid on any refund to an FFI that does satisfy this disclosure requirement. This relatively harsh rule is obviously designed to encourage FFIs to enter into FATCA disclosure agreements with the IRS in the first instance.
The FATCA provisions apply only to payments made after December 31, 2012. However, FATCA will not apply to payments made after 2012 on any obligation in existence on March 18, 2012, or to the gross proceeds received after 2012 from the disposition of any such grandfathered obligation.
Other International Tax Provisions
Additional relevant international tax provisions passed as part of the HIRE Act include:
Elimination of the disparate withholding tax treatment of U.S.-source dividends and payments contingent on the payment of a U.S.-source dividend (dividend equivalent payments) by treating the latter as a U.S.-source payment. Such dividend equivalent payments made after September 18, 2010, will be subject to U.S. withholding tax at a maximum rate of 30%, which may be reduced by treaty.
Repeal, prospectively, of the "foreign-targeted obligation" exemption for bearer obligations. Interest paid on bearer obligations issued after March 18, 2012, will be subject to withholding tax and will not qualify as "portfolio interest."
Supplementation of current foreign bank accounting reports (FBAR) required by the Bank Secrecy Act with new Internal Revenue Code reporting requirements. For tax years that began after March 18, 2010, U.S. persons must disclose specified foreign financial assets (SFFA) on their tax returns if the SFFA exceed $50,000 (or a higher amount determined by the IRS). SFFA include accounts maintained in FFI, foreign stock holdings, financial instruments issued by foreign persons, and interests in foreign entities. No reporting is required for interests held in a custodial account of a U.S. financial institution. Reporting failures are subject to a base penalty of $10,000, with incremental increases depending on the length of non-compliance. The IRS is authorized to issue regulations to eliminate duplicative reporting under the existing FBAR provisions and to exempt certain categories of nonresident aliens and residents of U.S. possessions.
Extension of the statute of limitations for tax purposes to six years with respect to understatements of income attributable to SFFA (including those exempted under the de minimis rule or by regulation) that exceed $5,000; the extension is effective for all returns for which the statute of limitations did not expire as of March 18, 2010.
Expansion of the accuracy-related penalty that applies in the case of negligence or disregard of the rules and regulations or a substantial understatement of income tax to include underpayments attributable to undisclosed foreign financial asset understatement, which includes failures to file reports under the new SFFA provision and under certain existing Internal Revenue Code provisions relating to foreign investment. This change is effective for tax years that began after March 18, 2010. The new penalty will be applied at a rate equal to 40% of the relevant portion of the underpaid tax.
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 ¶7170, U.S. International Withholding and Reporting Requirements.
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