In an effort to curb perceived tax abuses by U.S. persons with offshore bank accounts and/or investments, the US Congress passed broad, sweeping legislation intended to combat offshore tax evasion by such persons. Specifically, the Foreign Account Tax Compliance Act (“FATCA”) (signed into law on March 18, 2010) incorporates a new chapter 4 reporting regime that is designed to achieve this stated intent by imposing a severe withholding tax on certain entities that refuse to disclose the identities of these US Persons to US authorities.
- FATCA is US legislation which is designed to enable the US Internal Revenue Service (IRS) to obtain information about offshore accounts held by US taxpayers.
- FATCA generally requires a foreign financial institution (FFI) to report to the IRS certain information on offshore financial accounts held by US taxpayers. A FFI that is non-compliant will generally be subject to a 30% withholding tax on US sourced payments made to the FFI.
- Many Australian funds will not be able to rely on the exemptions in the proposed regulations implementing FATCA.
Which entities will be affected?
Under FATCA a ‘FFI’ is a financial institution which is a foreign entity.
Under FATCA, a ‘financial institution’ is defined as an entity that:
- accepts deposits in the ordinary course of a banking or similar business,
- as a substantial portion of its business, holds financial assets for the account of others, or
- is engaged primarily in the business of investing, reinvesting, or trading in securities, partnership interests, commodities or any interest (including a futures or forward contract or option) in such securities, partnership interests, or commodities.
The definition of a FFI is extremely broad and will generally include trust companies, investment managers, responsible entities, custodians and relevant investment funds.
What does a FFI have to do?
It requires a FFI who elects to comply with FATCA, to enter into an agreement with the IRS. FFIs which do so, will agree to:
- determine which of their accounts are US accounts (ie, an account held by a specified US person or a US-owned foreign entity);
- comply with IRS verification and due diligence procedures with respect to those accounts;
- report annually to the IRS on US account information;
- withhold 30% FATCA withholding tax on any pass through payment (referred to as a passthru payment in FATCA) to a recalcitrant account holder or another FFI which has elected not to participate in FATCA (ie, a non-compliant FFI);
- comply with any additional IRS information requests with respect to US account holders;
- in the case where domestic law prohibits the reporting by the FFI to the IRS of any of the information referred to above, the FFI must attempt to obtain a valid waiver of such law from each US account holder; and
- where such a waiver could not be obtained within a reasonable period of time, close the US account.
For FFIs that elect not to comply, the impact of the 30% withholding tax on any pass thru payment will make it difficult for that FFI to remain competitive with those that do sign up to FATCA, especially if it chooses to continue to invest in US capital markets either on its own behalf, or on behalf of US clients. As presently drafted, the FATCA withholding tax applies to a pass thru payment received by a non-participating FFI or recalcitrant account holders even though the payment would not ordinarily be subject to US taxation. The FATCA withholding tax can be reclaimed only if the FFI is the beneficial owner of the income. An FFI may also be able to benefit from a reduced rate of withholding tax under a double tax treaty (DTT) with the US.
Intergovernmental Agreements (“IGA”)
An IGA based on the Model IGA published by the United States Department of the Treasury in July 2012, would provide an FFI with an alternative means of complying with FATCA. In particular, it would remove the requirements for FFIs to:
- enter into individual FFI agreements with the U.S. Internal Revenue Service (IRS) (see above) and instead, would require FFIs to report the requisite information about their US accounts to the Australian Taxation Office (thus avoiding any conflicts with local laws such as data privacy);
- deduct FATCA withholding on ‘U.S. Source Withholdable Payments’ made to non-participating Foreign Financial Institutions (FFIs) (except in limited circumstances); and
- deduct FATCA withholding from the accounts of “recalcitrant account holders” or close such accounts.
The IRS has released two models for IGAs under FATCA. Under the Model 1 IGA, an FFI reports information to the tax authority in its own jurisdiction rather than the IRS. Under the Model 2 IGA, an FFI must report directly to the IRS. FFIs covered by the Model 1 IGA are not required to follow the final regulations, but FFIs covered by the Model 2 IGA are required to follow the final regulations except to the extent expressly modified by the Model 2 IGA.
The Australian Government is exploring the feasibility of an IGA with the US. The objective of such an agreement would be to minimise compliance costs for FFIs while enhancing the existing tax cooperation arrangements between Australia and the US. IGAs are a key element of FATCA compliance in many jurisdictions globally and, if implemented in Australia, are intended to alleviate some of the burden on our local banks and financial institutions. In November 2012, the Australian government officially announced their intention to begin discussions with the US about the possibility of Australia entering into an IGA.
In discussions with clients we have also noted that many Australian financial institutions are still awaiting the details of a potential IGA between Australia and the US in order to assess the full impact of the above final regulations on their businesses.
The Impact of FATCA on Fund Administrators
In practice, it is likely that the fund administrators will be the party that will be asked to carry out the majority of the additional work on behalf of their fund clients. This additional work may include additional due diligence procedures, preparing reports for submission to the IRS on an annual basis, and calculating any amounts subject to withholding and from whom. This can potentially result in a significant additional burden for the fund administrators of funds with U.S. investors or which invest in U.S. markets and will ultimately need to be passed on to investors.
FATCA Final Regulations
The FATCA laws have been developed to assist the US government in tracking down the overseas assets and income of US tax evaders.
Under the new regulations foreign financial institutions are required to identify all US customers, report back to the IRS and potentially withhold customer funds on certain types of income. Financial institutions that don’t comply face the prospect of incurring a 30% withholding tax on payments they receive from US sources.
Notwithstanding the possibility of an IGA between Australia and the US (see above) complying with the new requirements will still require substantial investment in 3 areas: identifying and documenting US customers, withholding 30% on certain payments to recalcitrant account holders and financial institutions that can’t or don’t want to participate, and reporting information to the IRS.
The implementation date for the new regulations has been pushed back to 1 January 2014, however Australian financial institutions will need to use this time to understand the impact of the changes and look for the best way to address the additional requirements within their business.