Significant Proposed Legislation Would Increase Compliance Costs For U.S. Payors And Impact Worldwide Recipients Of U.S. Source Income

Originally published November 10, 2009

On October 27, 2009, the Foreign Account Tax Compliance Act of 2009 (FATCA or FATCAT as referenced by some Hill officials) was introduced simultaneously in both houses of the U.S. Congress and endorsed by the Secretary of the Treasury, reflecting the joint drafting of the bill by the Congress and the Treasury Department.

Aimed at requiring the disclosure of income of U.S. persons investing through foreign entities, the legislation is far-reaching in its potential impact on both U.S. payors and foreign recipients. The legislation aims to prevent U.S. persons from hiding their identity behind a foreign corporation, trust, foundation or other type of foreign entity.

The proposed legislation likely will be enacted in late 2009 and would override the existing withholding rules effective for payments made on or after January 1, 2011. Thus, it is important to consider the potential impact now and provide any comments as soon as possible. It is difficult to see that the necessary administrative efforts by all involved parties—the government, U.S. payors and affected foreign entities—could be completed by the proposed effective date.

The key provisions are as follows.

• A withholding tax of 30% will be imposed on payments to foreign financial institutions (FFIs) that do not enter into agreements with the IRS. "Foreign financial institutions," a broadly defined term, will be required to enter into an agreement with the IRS under which the foreign entity will identify and report on the accounts maintained by U.S. persons (directly or through U.S.-owned foreign entities); otherwise, U.S. payments made to the FFI generally will be subject to 30% withholding tax. For an FFI that already is a Qualified Intermediary (QI), this new agreement will be in addition to the QI Agreement.
• • Included within the broad definition of "foreign financial institution" are hedge funds, private equity funds and securitization vehicles as well as retail and investment banks and insurance companies that sponsor investment funds.
  • Due diligence and verification procedures will be required to identify U.S. account holders.
  • • Certifications from account holders may be relied upon unless the FFI has knowledge or reason to know that the information provided in the certificate is incorrect.
  • If an FFI does not enter an agreement with the IRS, the withholding tax will apply to the entire payment to the FFI even if it has no U.S. account holders.
  • Although beneficial owners may claim a refund to which they are entitled, it is not clear how such beneficial owners could identify the validity of their refund claim to the IRS.
  • An FFI that is resident in a treaty country and is the beneficial owner of the payment may claim a refund if it qualifies under the applicable treaty, reflecting the difference between the 30% tax withheld and the applicable treaty rate. No interest will be paid.
  • U.S. payments will include not only investment income such as dividends and interest but also capital gains from sales of capital assets that produce U.S. source income such as dividends and interest.
  • • Although capital gains will be subject to withholding, they will continue to be exempt from U.S. tax. However, obtaining a refund could be difficult, as explained above.
• "Non-financial foreign entities" will be required to provide beneficial owner withholding certificates or certification of no "substantial U.S. owners" or be subject to 30% withholding tax. All foreign entities other than FFIs, "non-financial foreign entities," that receive U.S. payments will be required to provide a certificate from the beneficial owner or payee of its accounts that the beneficial owner does not have any substantial U.S. owners or the name, address and TIN of each substantial U.S. owner or suffer a 30% withholding tax.
• • The withholding agent may rely on such a certificate if the withholding agent does not know or have reason to know that the information provided by the certificate is correct and reports the information to the IRS.
• Definition of "substantial U.S. owner" will have no threshold ownership for foreign investment vehicles. A "substantial U.S. owner" is defined as a U.S. person that owns, directly or indirectly, more than 10% in value of the stock of a foreign corporation or profits or capital interests of a partnership. Significantly, however, for investment vehicles such as hedge funds and private equity funds, this threshold will be eliminated so that any interest, no matter how small, will be potentially subject to 30% withholding. Foreign investment vehicles generally are passive foreign investment companies (PFICs), so it is not surprising that in the bill there is no de minimis threshold as with PFICs.
• Withholding tax rules applicable to certain specific transactions, including total return swaps and foreign targeted bearer bonds, also will be modified.
• • Total return swaps and other similar types of arrangements will be subject to U.S. tax if the underlying income would be, which is contrary to current law.
  • • Withholding will be imposed on gross payments and not net amounts, even if no payment is required to be made after netting.
    • This provision is to be effective 90 days after the enactment of the legislation.
  • Bearer bonds for issuance outside the United States will no longer enjoy the exception from the rules under the Tax Equity and Fiscal Responsibility Act of 1982 and so will be subject to the excise tax and will no longer qualify for the portfolio interest exception.
  • • It is not clear how this will impact U.S. issuers of bearer bonds in bond markets where bearer bonds are commonly used.

One can quickly discern from the above summary that the proposed legislation will increase compliance costs for payors who must set up new systems for dealing with outbound payments. Essentially, the proposed legislation, because it overrides the existing withholding rules on foreign payments, will require detailed coordination rules. Because the existing withholding rules are intertwined with the U.S. backup withholding rules, it is easy to imagine many unintended issues that will need to be resolved. More immediately, payors must consider whether and, if so, how, to disclose the potential new requirements in their offering documents for stock and debt issuances.

Although payments to FFIs that enter into the new disclosure agreements will be readily identifiable to withholding agents, payments to other foreign entities will require more care because of the "reason to know" standard. FFIs will bear the burden of the "reason to know" standard and so will need to institute procedures that will permit all information of the institution to be available throughout the institution, including information gathered from "know your customer" rules and anti-money laundering requirements.

The breadth of the legislation covers all U.S. payments to the rest of the world because the provisions apply to payments of U.S. source income without regard to its ownership. Thus, payments that are made only to foreign persons that otherwise would be exempt from U.S. withholding tax (such as portfolio interest) will be subject to potential withholding unless the payee either enters into an agreement with the IRS or, if not a FFI, provides the necessary beneficial owner certificates.

© 2009 Sutherland Asbill & Brennan LLP. All Rights Reserved.

This article is for informational purposes and is not intended to constitute legal advice.