United States: IRS Issues Final Regulations To The Foreign Account Tax Compliance Act

On January 17, 2013, the U.S. Treasury and IRS released the long-awaited final regulations interpreting the new Chapter 4 of Subtitle A of the Internal Revenue Code of 1986, as amended, commonly referred to as the Foreign Account Tax Compliance Act (FATCA).

Background

FATCA was enacted to assist the IRS in detecting and discouraging tax evasion by U.S. taxpayers holding offshore investments, primarily in foreign financial institutions (FFIs). Under FATCA, a withholding tax is imposed on certain U.S. source payments made to FFIs and non-financial foreign entities (NFFEs) and certain non-U.S. source payments made by FFIs unless the recipients of such payments comply with FATCA or qualify for an exemption.

The IRS previously released three interim notices (Notice 2010-60, Notice 2011-34, and Notice 2011-53), proposed regulations, and an administrative announcement (Announcement 2012-42) providing an ever-evolving set of proposed rules and procedures to implement FATCA, and the IRS solicited comments from stakeholders with respect to these rules and procedures.

Early in 2012, the U.S. Treasury began negotiating and entering into intergovernmental agreements (IGAs) with foreign governments. The IGAs are an alternative means by which financial institutions located within participating jurisdictions can comply with FATCA. The IGAs were developed as a mechanism to encourage disclosure but respect the data protection and privacy laws of other jurisdictions, which may prohibit the due diligence and reporting of account information required under FATCA, as well as an incentive for foreign governments to cooperate with the U.S. Treasury's efforts to combat international tax evasion. The IGAs come in one of two models: Model 1 and Model 2. Model 1 involves taxpayer reporting to the taxpayer's home jurisdiction and then reporting by that jurisdiction to the United States. Model 2 involves direct reporting by foreign financial institutions to the IRS without violating local laws, supplemented by information exchange between the United States and the foreign government upon request. As of the date of this publication, the U.S. Treasury has signed a Model 1 IGA with the United Kingdom, Ireland, Denmark, Mexico, and Norway.

Notable Similarities and Differences Between the Final and Proposed Regulations

The final regulations adopt the same fundamental approach to FATCA as the proposed regulations. FFIs subject to the full FATCA regime must agree with the IRS to conduct due diligence with respect to their account holders, report on their U.S. accounts and the accounts of their recalcitrant and non-compliant account holders, withhold on certain payments made to other foreign institutions, and periodically verify to the IRS that these requirements have been met. The final regulations apply generally to the same types of payments and to the same types of institutions.

Although the basic framework is unaltered, the final regulations contain many changes, both large and small. The final regulations attempt to address comments received by the U.S. Treasury and the IRS and develop an approach to FATCA that balances the new law's policy objectives and the resulting compliance burdens. The following discussion highlights a selection of notable similarities and differences between the final and proposed regulations.

FFIs

The definition of an FFI consists of five categories of institutions: depository institutions, custodial institutions, investment entities, certain insurance companies, and certain holding companies and treasury centers. These categories were set out in the proposed regulations and remain unchanged in the final regulations.

Nonetheless, the final regulations modify the scope of these categories in notable ways:

• Depository and custodial institutions. The final regulations clarify the definitions of depository and custodial institutions. In particular, depository institutions specifically exclude entities that solely accept deposits as collateral or security under a sale or lease of property or similar financing arrangement.
• Investment entities. Under the final regulations, investment entities include entities that primarily conduct as a business on behalf of customers, (1) trading in certain financial instruments, (2) individual or collective portfolio management or investing, administering, or managing funds, money, or financial assets on behalf of other persons, or (3) otherwise investing, administering, or managing funds, money, or certain financial assets on behalf of other persons. Fund managers had not previously been included in the definition of financial institutions.
• New exemptions. The final regulations provide that certain enumerated financial institutions that would otherwise meet the definition of "FFIs" will not be considered FFIs. These carve-outs from the definition of an FFI were introduced in the IRS notices, modified in the proposed regulations, and generally adopted in the final regulations. The final regulations further add new categories of exempt FFIs, specifically certain holding companies, treasury centers, and captive finance companies of nonfinancial groups.
• IGAs. The IGAs use their own definition of a financial institution. This definition is consistent with the final regulations except, under certain circumstances, an entity might be a financial institution under the IGAs but not under the final regulations because the IGAs include certain catch-all language relying on the definition of "financial institution" set forth in the Financial Action Task Force Recommendations. Certain entities such as holding companies and treasury centers are specifically included within the definition of an FFI under the final regulations but are not specifically mentioned within the definition of a financial institution under the IGAs. As a result, it is possible that an entity residing in an IGA jurisdiction may be subject to FATCA and not benefit from the IGA.

Deemed-Compliant FFIs

The proposed regulations introduced, and the final regulations generally adopted, categories of financial entities that would be deemed to be compliant with FATCA (so called "deemed-compliant FFIs"). Deemed-compliant FFIs have substantially reduced FATCA obligations but must still satisfy certain certification requirements and in some cases limited due diligence and reporting requirements.

The final regulations add several new categories of deemed-compliant FFIs:

• IGA Model 1 FFIs. FFIs in IGA Model 1 jurisdictions that have complied with their respective IGA agreements will be considered to have satisfied all of the requirements to be deemed-compliant FFIs.
• IGA Model 2 FFIs. In general, the IGA Model 2 agreements contain special categories of deemed-compliant FFIs. If a foreign institution in an IGA Model 2 jurisdiction is treated as such under the IGA, the foreign institution will be considered to have satisfied all of the requirements to be a deemed-compliant FFI under the final regulations.
• Credit card issuers and investment vehicles. The final regulations provide that certain credit card issuers and investment vehicles for which a sponsor agrees to fulfill the reporting requirements under FATCA will be deemed-compliant FFIs.
• Limited life debt investment entities. Deemed-compliant FFIs will also include certain limited life debt investment entities in existence on December 31, 2011. This category was created to accommodate securitization vehicles, many of which will be unable to comply with the registration and due diligence requirements under FATCA but will be effective only until December 31, 2016.

The final regulations are generally consistent with the proposed regulations' required types of payments subject to FATCA withholding including U.S. source interest, dividends, and other fixed or determinable annual or periodical (U.S. source FDAP) income, gross proceeds from the disposition of property that can produce U.S. source interest or dividends, and certain payments made by participating FFIs to other foreign institutions ("foreign passthru payments").

Many practitioners were concerned that under the broad definition set forth in the proposed regulations, repayment of principal would be subject to FATCA withholding. Under the final regulations, repayment of principal and corporate distributions that are returns to capital will indeed be subject to withholding under FATCA. However, it should be noted that under the IGAs, the United States and the participating jurisdiction have "committed to work together...to develop a practical and effective alternative approach to achieve the policy objects of...gross proceeds withholding that minimizes burden."

The final regulations replace the ordinary course of business exception included in the proposed regulations with a more comprehensive exclusion for "excluded nonfinancial payments." The final regulations explicitly describe payments that will be excluded from FATCA withholding and payments that will be subject to FATCA withholding pursuant to the excluded nonfinancial payment exclusion.

Timing of FATCA Withholding

In response to concerns regarding the practical difficulties surrounding the implementation of FATCA, the U.S. Treasury and the IRS agreed to phase in withholding under FATCA over the next several years based on the type of payment being made by the withholding agent.

Therefore, withholding agents (including FFIs) will not be required to withhold under FATCA on a payment before such payment's applicable withholding date (or pursuant to the applicable grandfathering rules, as described in the following section), notwithstanding the fact that the payee may not be in compliance with FATCA. It is important to keep in mind that even if FATCA withholding does not apply, withholding under Chapter 3 of the Code may still apply.

The following is a summary of the applicable withholding dates based on whether the payment is FDAP, gross sale proceeds, or foreign passthru payments.

• U.S. Source FDAP. Withholding with respect to a payment of U.S.-source FDAP will commence on January 1, 2014 through January 1, 2017 depending on the type of payment (e.g. whether the payment is made under an obligation entered into before January 1, 2014) and the type of recipient (e.g. whether the recipient is a "prima facie" FFI).
• Gross sale proceeds. The applicable withholding date under the final regulations for payments of gross proceeds from the sale or disposition of property (including the repayment of principal under a note) is January 1, 2017. Note, under the IGAs, the exact rules (including the applicable withholding dates) in connection with gross proceeds withholding continue to be reserved as of the date of this publication.
• Foreign passthru payments. Foreign passthru payments are non-U.S. source payments made by FFIs who have entered into a FATCA agreement with the IRS. These payments have been the source of much criticism. In Notice 2011-34, the U.S. Treasury provided basic rules in connection with foreign passthru payments. Under the proposed regulations, the earliest date for foreign passthru payment withholding would be January 1, 2017, though the exact details regarding foreign passthru payments were reserved. Under the final regulations, the earliest withholding date continues to be January 1, 2017 and the exact details of foreign passthru payments continue to be reserved. Note, the IGAs provide, similar to gross proceeds withholding, that the IGA countries will commit to develop a "practical and effective alternative approach" to foreign passthru payment withholding.

Grandfathered Obligations

The proposed regulations provided that certain payments made under non-equity instruments or agreements would not be subject to FATCA withholding if such instruments or agreements were entered into before January 1, 2013 (subject to a material modification after such date).

The final regulations extend the grandfathering date to January 1, 2014. In addition, the final regulations clarify and expand the scope of grandfathered payments in the following notable ways:

• Collateral. Grandfathered obligations include any agreement requiring a secured party to make a payment with respect to, or to repay, collateral posted to secure a grandfathered obligation.
  
  

• Relevant dates. The relevant date to determine whether a debt obligation is grandfathered is the issuance date. For a non-debt obligation, the relevant date is the date a legally binding agreement establishing the obligation (e.g. a credit agreement establishing a revolving credit facility for a fixed term) is executed.
  
  
• Dividend equivalents and foreign passthru payments. Dividend equivalents and foreign passthru payments are grandfathered until six months after the implementation of the final regulations governing such payments.
• Withholding agents other than issuer. A withholding agent other than the issuer (or agent of the issuer) may rely on a written statement to determine whether the obligation is grandfathered, absent actual knowledge.

Due Diligence

FFIs subject to FATCA must comply with onerous due diligence requirements with respect to their account holders to determine U.S. status. These requirements involve searching records and collecting information from account holders in accordance with an intricate set of rules. The precise process will depend on whether the account holder is an individual or an entity, and whether the account is a "pre-existing account" or a new account with significantly greater due diligence for high-value individual accounts and exceptions from due diligence for low-value accounts.

The final regulations retain the same basic framework for due diligence but relax certain requirements. Notable changes include the following:

• For pre-existing account holders, FFIs can rely on a pre-FATCA Form W-8 instead of an updated withholding certificate in order to determine the FATCA status of an account holder.
• New accounts of a pre-existing customer under certain circumstances can be treated as a pre-existing obligation. In some circumstances, this will avoid the need for FFIs to collect new information from pre-existing customers.
• The final regulations provide guidance on how an FFI can identify the FATCA status of accounts received from another entity pursuant to a merger or acquisition.
• The final regulations expand the use of alternative forms that FFIs can collect upon opening new accounts. Further, third-party credit agency information may be used for due diligence purposes under certain circumstances.
• In some situations, documentation will remain valid indefinitely, including withholding certificates provided by a compliant FFI or certain deemed-compliant FFIs that have furnished a verified GIIN (discussed below).
• The final regulations extend certain time frames for completing due diligence. For example, with respect to pre-existing entity accounts, FFIs must complete due diligence procedures within six months of the effective date of its FFI Agreement (discussed below) for account holders who are prima facie FFIs. For other pre-existing entity account holders, the applicable deadline is two years. For pre-existing obligations issued in bearer form by an investment entity, due diligence must be completed at the time a payment is collected.

Financial Accounts

Due diligence conducted by FFIs is limited to "financial accounts." The definition of a financial account mirrors the four-part definition of an FFI. That is, financial accounts consist of depository accounts, custodial accounts, debt and equity interests, and insurance and annuity contracts. Debt and equity interests issued by depository and custodial accounts are not financial accounts unless their value is determined by reference to an underlying asset that produces withholdable payments. There is also a general exception for debt and equity interests regularly traded on an established security market.

These parameters of a financial account were laid out in the proposed regulations and generally adopted by the final regulations, with a few notable exceptions:

• Escrow accounts. The final regulations exclude certain escrow accounts for commercial transactions.
• Depository accounts. The final regulations clarify that depository accounts must be held by an entity engaged in a banking or similar business for which such institution is obligated to give credit. The final regulations also provide that depository accounts do not include negotiable debt instruments traded on a regulated market or over-the-counter market and distributed and held through financial institutions.
• Debt and equity issued by advisors and managers. Financial accounts do not include debt or equity interests in investment advisors or asset managers unless the value of such interests are determined primarily by reference to assets that give rise to payments that would be subject to FATCA withholding or unless certain anti-abuse rules are met. This treatment parallels the treatment of equity and debt interests issued by banks and custodians.
• Debt and equity in holding companies and treasury centers. Financial accounts do not include debt or equity interests in holding companies and treasury centers of expanded affiliated groups whose income is derived primarily from "active NFFEs" (generally, NFFEs if less than half of their income is passive and less than half of their assets produce passive income), depository institutions, custodial institutions, and insurance companies, except to the extent the debt or equity tracks the performance of an investment entity or passive NFFE or the value of such debt or equity is determined by reference to an asset that gives rise to withholdable payments. This rule was created in response to comments that holding companies often raise funds for their subsidiaries by issuing equity or debt usually held through custodial institutions, and that these custodial institutions are in a better position to document holders and report and withhold on such instruments.
• Debt and equity determined by underlying asset. The final regulations clarify that the value of an equity interest is determined by reference to an asset that gives rise to a withholdable payment if the amount payable upon redemption of the interest is either secured or determined primarily by reference to assets that give rise to withholdable payments. The value of a debt interest is so determined if the debt is convertible into stock of a U.S. person, amounts payable as interest or upon redemption of the debt are determined primarily by reference to profits or assets of a U.S. person, or the debt is secured by assets of a U.S. person.
• Regularly traded. The final regulations clarify that an interest is not regularly traded if the holder of the interest (other than a financial institution acting as an intermediary) is registered on the books of the investment entity, except to the extent a holder's interest is registered before January 1, 2014.

Reporting Requirements

FFIs must report information about their U.S. account holders and recalcitrant and non-compliant account holders to the IRS. Under the final regulations, the earliest reporting date is March 31, 2015, with respect to accounts held in 2013 and 2014. Under the proposed regulations, the earliest reporting date was September 30, 2014.

Limited FFIs and Affiliated Groups

If not every member of an "expanded affiliated group" is FATCA compliant, every member of the group will be considered non-compliant.

This rule has been the subject of much criticism. Affiliated groups may have members that are prohibited from complying with FATCA as a result of local data protection and privacy laws. In recognition of the legal difficulties faced by some group members in complying, the proposed regulations created, and the final regulations adopt, transitional rules providing that an expanded affiliated group can be FATCA compliant notwithstanding the fact that some of its members are non-compliant. These transitional rules cease to apply beginning on January 1, 2016.

The final regulations also add a new anti-abuse rule that disregards ownership changes, voting rights, or entity forms that attempt to avoid the expanded affiliated group rules.

In contrast to the final regulations, a group member located in an IGA jurisdiction may continue to be non-compliant without affecting the FATCA status of its other group members. It is possible that this difference between the IGAs and the final regulations was intended to encourage countries to enter into an IGA.

Verification

The final FATCA regulations, consistent with the proposed regulations, provide that a responsible officer must periodically certify that an FFI's obligations under FATCA have been met.

The final regulations provide that certifications must be made no later than 60 days following two years after the effective date of the FFI Agreement (discussed below).

The final regulations also provide that if a responsible officer cannot make the required certification, he or she may make a qualified certification stating why the general certification cannot be made and that corrective actions will be taken by the responsible officer.

FFI Agreements

FFIs subject to FATCA must enter into an agreement with the IRS to comply with FATCA (called an "FFI Agreement").

• Content. The substantive requirements applicable to an FFI under the FFI Agreement are set forth in the final regulations. According to the U.S. Treasury and IRS, the exact terms of the FFI Agreement, which will be consistent with the final regulations, will be published in a future revenue procedure.

• Registration. FFIs will be able to register with the IRS through an online portal. The portal is expected to be used to register with the IRS, enter into an FFI Agreement, and obtain a Global Intermediary Identification Number ("GIIN"), which will be issued to registered FFIs. According to the U.S. Treasury and IRS, the portal will be accessible no later than July 15, 2013. The IRS will electronically post the first list of compliant and deemed-compliant FFIs on December 2, 2013. To be included on the December list, FFIs must register by October 25, 2013.
• Effective date. The earliest effective date of an FFI Agreement is December 31, 2013, for FFIs that receive a GIIN prior to January 1, 2014.
• Default. The final regulations clarify that an event of default under an FFI Agreement will not result in its automatic termination. If the IRS becomes aware of an event of default, the IRS will deliver a notice and permit the FFI to develop a plan of remediation. Upon any subsequent failures, the IRS may terminate the FFI Agreement within a reasonable period of time, subject to a request for reconsideration by the FFI.

Conclusion

The issuance of the final regulations represents the latest milestone in the evolution of FATCA. The final regulations seek to eliminate unnecessary burdens and bring clarity to previously unanswered questions regarding the procedures, impact, and cost of FATCA. For example, the final regulations extend the grandfathering period by one year. However, the final regulations also raise concerns and new questions regarding the scope of FATCA. In particular, the final regulations confirm that repayment of principal will be subject to withholding, at least with respect to foreign institutions located outside of IGA countries. It is not surprising that gross proceeds withholding, which has been the subject of much controversy, has been delayed twice since the concept was introduced in the IRS notices. It is also unsurprising that the controversial concept of foreign passthru payment withholding remains reserved under the final regulations. Importantly, gross proceeds and foreign passthru payment withholding remain open issues in IGAs countries.

Despite the final regulations, FATCA and the IGAs require ongoing monitoring, including the publication of highly anticipated guidance regarding foreign passthru payments.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.