QI/FATCA Agenda March 2010

 

Foreign Account Tax Compliance Act (FATCA)

FATCA regulations: „Baby-QI“ or QI's full-grown sibling?

This information is supposed to acquaint the reader with the proposed US Foreign Account Tax Compliance Act („FATCA“). The sponsors describe the Bill as intended to strengthen information reporting and compliance with respect to offshore accounts and entities and to provide the Internal Revenue Service (IRS) with new administrative tools to identify and discourage offshore tax abuse. The press release accompanying the introduction of the Bill indicated that the Joint Committee on Taxation (JCT) has estimated the provisions would raise approximately $8.5 billion over 10 years.

 

FATCA at a glance

As the FATCA proposals partly resemble the QI regime, which has been in effect from 2001, FATCA was also called „Baby-QI“ in its nascent phase. However, considering the ramifications it will likely have on business decisions, client segmentation and reporting, it appears that FATCA will rather develop to be QI's full-grown sibling.

 

FATCA does not replace QI but rather supplements it

Under the existing QI agreements, which most of the world’s major banks have entered into with the IRS, those banks have basically agreed to identify US persons holding US securities and to report their income emanating from these US securities. Figure 1 shows this in the shaded triangular field.

All other fields do not capture customer information under the current QI regulations.

In return for the reporting duties under the QI, qualified intermediaries had been given the possibility to make treaty benefits available to their non-US customers in respect of US securities on a pooled and anonymous basis.

 

With budget deficits to be covered and healthcare budgets to be financed, the US government has now identified other fields in this landscape which need to be captured by FATCA. In particular, the income arising from non-US securities as well as income from both, US and non-US securities received by foreign entities with substantial US shareholders would need to be reported under the proposed regulations.

Figure 2 shows the yellow shaded fields, which the FATCA is supposed to capture, thus closing the perceived gaps in the landscape. It should be noted that the US Treasury is not seeking to receive information about non-US investors (holding directly or indirectly).

 

How does FATCA work?

Essentially, each foreign financial institution ("FFI") is required to have itself "accredited" with the IRS and agrees to submit the following information to the IRS on an annual basis:

• Name, address and TIN of all US persons and of foreign entities with US shareholders (> 10%)
• Account / custody account number
• Value of the account / custody account
• All net payments in favour of the account / custody account and all net withdrawals (irrespective of whether US or non-US securities)
• Answer to questions (scope not yet defined) of the IRS pertaining US accounts
• Furthermore, the FFI must ask the client to waive its right to banking secrecy, if any. If the FFI fails to do so, it must discontinue the client relationship.

The definition of an FFI is broad: whilst banks are generally assumed to be seen as FFIs, also wealth mangers, investment funds and even advisors (e.g. family offices) which receive fees over a certain threshold amount are considered FFIs. Where the FFI does not enter into an agreement with the IRS as outlined above, the FFI's US withholding agent (or another FFI in its position as an downstream custodian) is required to levy 30% withholding tax on

• all dividend and interest payments (essentially, all FDAP (fixed, determinable, annual, periodical) payments as well as on all interest payments hitherto exempted under the portfolio interest exemption),
• on all proceeds (!) resulting from the sale of US securities,
• equity swap payments where the swap payment is referenced to a US security.

Hence, FATCA does—unlike the QI regime—not offer a quid pro quo in the sense, for instance, that it alleviates treaty access as under the QI regime, but it rather threatens to penalize the entire client community of an FFI with the 30% withholding unless the FFI agrees to furnish the requested information to the IRS.

 

Why do you need to know about FATCA?

Simply because FATCA will impact your business strategy for various reasons:

• FATCA is not only a "purely" tax operational question / reporting issue. Clients need to be properly identified and documented. The FFI will need to collect more and more detailed information on the client (particularly in case of foreign entities with a direct or indirect substantial US owner).
• Decisions need to be taken if a financial institution wants to become an accredited FFI and/or retains its QI status or any combination of both. This decision will vastly impact the business strategy of every financial institution and, besides the client documentation and reporting questions, reputational issues need to be considered.
• Decisions need to be taken how to stratify affected clients and how and whether these clients will be serviced. These are decisions of a more strategic nature which would possibly involve the management board and the executive board.
• New reporting structures will need to be implemented, which entails changes in the IT landscape of a financial service provider.
• It appears that these regulations will be implemented sooner rather than later for all payments which fall due after December 31, 2012.

 

What are the takeaways?

 

• Who is affected?
  Generally, all non-US banks, investment funds (unclear as of yet if all publicly offered retail funds will be affected), wealth managers and advisors (e.g. family offices).
   
• How?
  Requirement to essentially report on all of US customers (direct customers or US persons as substantial shareholders in non-US entities) and requirement to answer IRS' questions on these clients as well as to ask these clients to waive their right to banking secrecy, if any, failing such, to discontinue servicing such clients.
   
• …but that's the same as the existing QI?
  FATCA comes on top of the QI and its reporting duties go beyond the QI's duties. Essentially, all investments held on behalf of US clients need to be reported.
   
• … and if I don't want to become an FFI?
  The IRS cannot force a financial service provider to become an FFI. However, in such a case, the entire client population (notwithstanding that they are non-US persons) will suffer 30% withholding on all US sourced payments, equity swap payments referenced to US securities as well as on all sales proceeds resulting from the alienation of US securities.
   
• …and if I neither want to service US clients nor buy or sell US securities?
  Then, essentially, neither the QI agreement nor FATCA is likely to have an impact on your business. However, as a non-accredited FFI, the 30% NRA withholding will still apply. Furthermore, if US clients continue to be served, the IRS still has the possibility – where applicable – to require administrative assistance under a double tax treaty. In addition, reputational issues should be considered.
  • Understand the contents of FATCA
  • Understand the ramifications on my client base
  • Understand the impact on my business model (and probably take decisions to alter the business model)
  • Understand the impact on my client acceptance procedures (and amend procedures as applicable)
  • Understand the impact on my reporting procedures and systems (and amend procedures as applicable)
     
• How can Ernst & Young help?
  Besides understanding the pertinent facts – as mentioned above – Ernst & Young can assist in the following fields:
  
  • Scenario-analysis (through a guided rapid assessment workshop)
  • Customer base segmentation according to a pre-defined framework
  • Due diligence & reporting gap-analysis
  • Specification of enhancements on operational processes and systems
  • Action plan, to be executed when proposed US tax reforms are enacted
  • Project governance support
  To ensure the success of adaption to the possible new tax framework, interdependencies management between Front Office, Compliance, Legal and IT functions will be critical. EY has set up an interdisciplinary team consisting of Tax and Business advisors to support you throughout the emerging priorities and initiatives.