In 2010, Congress and President Obama carried into law the Hiring Incentives to Restore Employment Act (“HIRE Act”). The HIRE Act contained a set of provisions named the Foreign Account Tax Compliance Act (“FATCA”), which the U.S. Treasury stated “targets the illicit activities of some wealthy individuals who use offshore accounts to evade millions of dollars in taxes.” Unfortunately, in practice FATCA is much broader than targeting only wealthy individuals evading U.S. taxes through offshore activities – it casts a broad net covering usually all offshore activities. Moreover, it is important to note that FATCA obligations are in addition to the existing obligations regarding disclosure, reporting and withholding under the Internal Revenue Code.
A primary thrust of FATCA is to require non-U.S. foreign financial institutions (“FFIs”) to report the income and assets of US persons to the US annually. FFIs that do not comply with this mandate are subject to a mandatory withholding U.S. tax of thirty (30) percent. The withholding tax applies to both income payments (e.g., interest and dividends), and principal payments as well (e.g., gross proceeds received from securities sales and payment of debt principal). Additionally, the thirty (30) percent FATCA tax cannot be reduced by claiming the benefits of an existing income tax treaty, and the thirty (30) percent FATCA tax applies even if the underlying transaction results in a loss for U.S. income tax purposes.
In addition to required withholding, FATCA sets civil penalties that are more severe than under prior law. Before FATCA, a taxpayer who filed a tax return that contained an understatement attributable to nondisclosed foreign financial assets faced a 20% penalty and the statute of limitation for violations was three years. FATCA increased the penalty for understatements attributable to nondisclosed foreign financial assets to 40% and extended the statute of limitation to six years. Finally, a minimum $10,000 penalty will be assessed against the taxpayer—and it can reach up to $50,000 per year—in addition to any taxes that are owed stemming from the discovery of undisclosed accounts.
Many countries have entered into agreements, named intergovernmental agreements, with the U.S. government in order to comply with FATCA. There are two types of intergovernmental agreements (“IGAs”) that have emerged from the FATCA legislation. Regardless of how the agreement is structured, the basic facts are the same: banks and other foreign financial institutions must provide U.S. taxpayers account information or face 30% withholding on certain U.S. source payments made to them. That threat alone will be an incentive for banks to hand over taxpayers information to the IRS.
Over 30 countries have already entered into IGAs with the United States. These nations include all of the other G7 members (Canada, France, Germany, Italy, Japan, and the U.K.), and every day seems to bring announcements that more countries are cooperating with FATCA’s provisions. With FATCA starting now, the U.S. government will have the information it needs to go after plenty of Americans who have not disclosed their overseas accounts.
The term FFI is broadly defined. It includes commonly thought of FFIs, such as banks, brokers, and insurance companies. However, it also includes investment companies and trust companies. The inclusion of investment companies and trust companies in the definition of FFI is not limited to entities that hold themselves out and offer their services to the public, but also includes investment structures catering and limited to family members. A few personal holding companies and private trusts may be able to avoid FFI status; however, the few that can escape FFI status will not be able to escape FATCA. Instead, most of the escapees will be classified as passive non-financial foreign entities (“NFFEs”). Passive NFFEs will still need to disclose the identity and tax residency of their interest holders to their custodian, brokers, or other financial instructions to avoid the thirty (30) percent FATCA tax.
FATCA requires FFIs to take affirmative steps with both the IRS and with regards to their internal procedures. FFIs will generally need to register with the IRS, obtain a new Global Intermediately Identification Number (“GIIN”), conduct certain due diligence procedures and report certain information to the IRS in order to avoid the thirty (30) percent withholding tax. Alternatively, some FFIs may be eligible to report this information to their local government which will then in turn report this information to the IRS. While FFIs can register for GIIN at any time, FFIs are strongly advised to complete registration with the IRS and receive their GIIN ASAP. The IRS has stated that the first published FFI list will occur on July 1, 2014. The July 1, 2014 FFI list is the final FFI list that will be published prior to the start of FATCA withholding on July 1, 2014.
Recently, the IRS in Notice 2014-33 announced that calendar years 2014 and 2015 are regarded as transition periods for enforcement and administration of FATCA. This notice grants FFIs and other entities that are obligated to withhold FATCA taxes a limited amount of discretion implementing FATCA’s numerous provisions assuming these FFIs undertake their FATCA obligations in good faith under the existing FATCA Treasury Regulations. This good faith transaction period will provide a limited time frame during which FFIs and others can exercise some reasonable discretion in implementing FATCA’s due diligence, withholding and reporting requirements. However, nothing within Notice 2014-33 delays or suspends the requirement to obtain a GIIN, or for FFIs to withhold FATCA tax for FATCA payments to non GIIN providing taxpayers.
Many U.S. persons conduct their financial affairs through privately-held investment vehicles for both privacy and wealth planning purposes. These privately-held investment vehicles come in a variety of different forms, generally selected after a thoughtful consideration of the relative benefits and burdens, including both nontax and tax aspects of each structure.
Oftentimes these structures are placed in international locations. International locations often have more favorable laws or judicial systems than are available in the U.S. The placement of these structures in an international financial center generally has more to do with favorable underlying laws or access to an international investment market than more nefarious motives such as tax evasion (which is illegal in almost all jurisdictions, including in the U.S.). Unfortunately, FATCA paints all U.S. persons with the same broad brush regardless of the underlying facts, and hence applies a burdensome uniform set of rules and regulations to both the innocent and the mal-intentioned.
Private investors need to recognize that FATCA is not going away and is now in full force and effect. Registering, establishing the required procedures, and demonstrating the requisite level of due diligence and documentation require time, something that is now in very short supply. Accordingly, action needs to be undertaken immediately, especially by FFIs, to become FATCA compliant. Becoming FATCA compliant now will allow private investment vehicles to avoid becoming subject to the new thirty (30) percent FATCA tax on future receipt of payments subject to FATCA’s withholding provisions. We strongly advise 1.) completing registration with the IRS and receiving a GIIN ASAP if required to do so and 2.) a thorough review of your current international structure to analyze what additional steps are necessary to become fully compliant for FATCA purposes.