FATCA: a guide for trusts and companies
The Foreign Account Tax Compliance Act (FATCA), enacted on 18 March 2010, creates historic client identification, disclosure and withholding obligations as part of the ongoing US effort to fight tax evasion. These obligations effectively require affected non-US banks, custodians and funds and other so-called ‘financial institutions’ to choose between implementing FATCA or exiting the US investment market for themselves and their clients. While much of the attention surrounding the legislation has been on non-US banks and investment funds, FATCA also affects non-US trust companies and virtually all family trusts.
On 8 February 2012, the Internal Revenue Service (IRS) released long-awaited proposed regulations containing rules on information reporting and withholding under FATCA. These will come as a welcome relief to many non-US financial institutions, as they allow additional time to implement procedures to comply with this controversial new US regime and contain other new provisions that should simplify the compliance effort and reduce implementation costs. However, significant issues remain unresolved.
The proposed regulations define entities that in the ordinary course of their business engage in the provision of trust or fiduciary services as ‘foreign financial institutions’ (FFIs). Therefore, trust companies, including private trust companies, will clearly be subject to FATCA. However, because this definition applies only to entities that engage in such activities, it appears that a non-US individual acting as a trustee would not be subject to FATCA.
Until now, it has been unclear whether trusts may themselves generally be classified as FFIs, or whether they should instead be treated as ‘non-financial foreign entities’ (NFFEs). In addition, it has been unclear whether, and in what circumstances, US beneficiaries may trigger a reporting obligation. In fact, even the issue of who constituted a beneficiary for FATCA was unclear. The proposed regulations have substantially clarified these issues by providing guidance as to how grantors and beneficiaries should be attributed ownership in trusts, but additional guidance is still required.
Any entity classified as an FFI, including trust companies and most family trusts that engage in investment activities, will generally be required to either enter into an agreement (FFI agreement) under which the FFI will be required to examine its records to determine whether there are indicia that its ‘account holders’ are US citizens, green-card holders or tax residents, or entities substantially owned by US persons and to report this information to the IRS. Although the IRS and Treasury continue to work on a draft FFI agreement and have announced that they intend to release this in the first half of this year, no specific release date has been set.
Subject to certain exceptions, FFIs refusing to enter into an FFI agreement will suffer 30 per cent gross withholding on all amounts invested into the US. This withholding tax will apply to virtually all amounts invested by an FFI into the US, whether for its own account or for that of its ‘account holders’, regardless of whether or not they are US persons, including US source dividends, interest, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, or other ‘fixed or determinable annual or periodic’ gains, profits, or income (FDAP) and the gross proceeds from the sale of any property that could produce US source interest or dividends.
FFIs refusing to enter into agreements will suffer 30 per cent gross withholding tax
Ultimately, FFIs will be required to deduct and withhold tax at a 30 per cent rate on ‘passthru’ payments to other non-US financial institutions that are not compliant with an FFI agreement or to any ‘recalcitrant account holder’, unless the FFI elects to be withheld upon with respect to so much of the payment as is allocable to these recalcitrant account holders and non-compliant FFIs and waives any applicable treaty benefits. FFIs will be required to close the account of any recalcitrant account holder that refuses to waive bank secrecy laws.
FFIs are required to report information about their own account holders, and accounts held by members of their ‘expanded affiliated group’ must also be reported. Essentially, this ‘expanded affiliated group’ reporting requirement means that if one member of a corporate group enters into an FFI agreement, all affiliated financial institutions will effectively be required to do so as well.
The proposed regulations provide guidance as to the procedures FFIs will have to undertake in determining which account holders are or may be US persons. Their approach is more reliant than previous guidance on an FFI’s existing customer intake and know your customer/anti-money laundering procedures, particularly with respect to new accounts.
Pre-existing individual accounts with a balance or value of USD50,000 or less and pre-existing entity accounts with a balance or value of USD250,000 or less are exempt from review. Accounts with a balance or value in excess of these thresholds but less than USD1 million will be subject only to review of electronically searchable records, i.e. information that can be accessed using a database search.
The previous guidance had introduced the concept of a ‘private banking test’, under which private bankers, wealth managers and certain other relationship managers, seemingly including trustees, connected to the accounts of high-net-worth individuals would be subject to more stringent compliance obligations. Such relationship managers would have been required to ‘perform a diligent review’ of their paper and electronic files and other records to determine whether a client (or any associated family member) is a US person, including both US citizens and US green-card holders. The proposed regulations substantially modify this concept, and do not require FFIs to make a distinction between private banking and other accounts. However, as discussed below, FFIs generally remain responsible for their relationship managers’ knowledge of a client’s US status.
Manual review of paper records (limited to certain categories of paper records) will only be required where the account balance exceeds USD1 million – an increase from the previous USD500,000 threshold. However, if an enhanced review beyond a review of electronically searchable records is required because the account value exceeds USD1 million, an enquiry into the relationship manager’s actual knowledge of indicia of US ownership is required. The term ‘relationship manager’ is broadly defined, and it is likely to be necessary to survey a number of different trust officers to determine whether they have actual knowledge that a settlor or beneficiary of a given trust is a US citizen, resident, or green-card holder. FFIs will need to implement appropriate policies and procedures to ensure compliance with this requirement.
The background to the proposed regulations states the intent is that FFIs that comply with the due diligence requirements outlined in the proposed regulations will be treated as compliant and will not be held to a strict liability standard, thereby placing significant importance on an FFI’s due diligence procedures. Verification of compliance through third-party audits will not be mandated, and FFIs may generally rely on periodic internal reviews rather than external audits. While third-party audits will not be mandated, each FFI will need to designate a responsible officer to certify compliance.
Trust companies will need to determine whether the trusts for which they act as trustee are grantor trusts or non-grantor trusts for US tax purposes. For a grantor trust, the grantor will be treated as the owner of the account. By contrast, for a non-grantor trust, the trust itself will be considered the owner of the account. If only a portion of the trust is treated as owned by the grantor, the grantor will be treated as the owner of the account with respect to that portion, and the trust will be considered the owner of the remaining portion. This will affect the determination by a trust company of whether an account has any substantial US owners, as well as whether the account is exempt from the due diligence requirements under the de minimis exemptions.
From the trust company’s perspective, non-US grantor trusts with a US grantor will be US accounts. However, accounts held by non-US grantor trusts that have a non-US grantor should be treated as owned directly by that non-US grantor and, therefore, should not be US accounts regardless of whether the trust makes distributions to US beneficiaries. By contrast, in the case of a non-grantor trust the determination of whether there is a substantial US owner should be based on the attribution rules.
The proposed regulations set out rules for determining when a US person will be treated as having a beneficial interest in a trust, including those based on attribution and constructive ownership rules, to determine whether a US grantor or beneficiary of a non-US trust is a substantial US owner of a foreign entity. The proposed regulations clarify that proportionate ownership is to be determined based on whether a beneficiary is entitled to mandatory distributions, purely discretionary distributions, or a combination of the two.
If a US beneficiary is entitled to mandatory distributions, their interest will be determined based on the value of that interest as determined under actuarial principles under s7520, subject to a USD50,000 de minimis threshold. If they may only receive discretionary distributions, then the value will be determined based on the amount of distributions received by that beneficiary over the prior calendar year compared to the distributions received by all other beneficiaries, subject to a USD5,000 de minimis threshold. If a US beneficiary may receive both mandatory and discretionary distributions, the determination is then based on the s7520 value combined with the sum of the value of all discretionary distributions.
Previous guidance had suggested that certain trusts and family investment entities that have a ‘small number’ of direct and indirect owners or beneficiaries could be exempted from the requirement that they enter into an FFI agreement if they met certain conditions. Unlike previous guidance, the proposed regulations contain no exception for these ‘small family trusts’.
Many non-US holding companies owned by trusts will be considered FFIs
Therefore, it appears that, in the view of the IRS, trusts or family investment entities that are ‘primarily’ engaged in the investing, reinvesting or trading of securities should themselves be considered FFIs. Representatives of the IRS and Treasury have informally confirmed that this is their view. Under this test, it appears that virtually all family trusts would themselves be FFIs, although they would be NFFEs if the trust or family entity does not ‘primarily’ engage in securities investment, e.g. perhaps where the trust primarily holds artwork, land, yachts and planes, family homes or active businesses.
Moreover, representatives of the IRS and Treasury have also publicly expressed the view that few passive corporations will be NFFEs, and that virtually all passive corporations that primarily invest in securities will be FFIs. Therefore, it seems that virtually all holding companies employed by non-US trust structures to hold bankable assets will themselves be FFIs.
Trusts that are FFIs would generally be required to determine whether any of their account holders are specified US persons based on the attribution rules, i.e. based on either s7520 actuarial valuation, pattern of prior year distributions, or a combination thereof depending on whether distributions are mandatory or discretionary. It seems that many non-US holding companies owned by trusts will be considered FFIs, and will have to engage in a similar analysis under rules that would attribute ownership of these companies to the grantor or beneficiaries of the trust.
It appears that the IRS believes trusts that are FFIs should be treated as such because they fall within a category of entity that ‘primarily’ engages in investment or trading in securities, as prior guidance has hinted might be the case. If this is, in fact, the basis on which the IRS would regard trusts as FFIs, then the 10 per cent threshold normally relevant to the determination of whether a trust has any ‘substantial US owners’ would not seem to be relevant to trusts that are FFIs, as it follows that a reduced 0 per cent threshold would instead apply. If this reduced threshold does apply, then if a US beneficiary has any interest in a non-US trust that is an FFI beyond the limited de minimis thresholds, the trust will be required to report such beneficiary as a US owner.
Many trusts and holding companies that are FFIs may qualify for deemed-compliant status and potentially avoid the need to enter into separate FFI agreements provided that they meet the criteria to be treated as ‘owner-documented’ FFIs, and they hold an account with a participating FFI and withholding agent that agrees to perform reporting on their behalf.
The proposed regulations indicate that deemed-compliant status for owner-documented FFIs will be on a withholding agent specific basis. Such owner-documented FFIs will generally be required to provide withholding agents and/or participating FFIs with which they hold accounts with a withholding certificate, annual owner reporting statements and documentation for each individual, specified US person and owner-documented FFI, exempt beneficial owner or NFFE that directly or indirectly holds an interest. For a grantor or simple trust, a foreign grantor trust or foreign simple trust withholding certificate may be substituted for the owner reporting statement.
Alternatively, owner-documented FFIs may provide an auditor’s letter from an independent and unrelated accounting or law firm with a location in the US certifying that that firm has reviewed the FFI’s documentation with respect to its owners, and that no owner who has a direct or indirect interest is a non-participating FFI, specified US person, or passive NFFE with any substantial US owners.
FATCA has faced a great deal of criticism in Canada, the EU and Asia because of concerns that this new regime will result in significantly increased compliance costs for financial institutions. In fact, FATCA client identification, disclosure, withholding and accounting closing requirements may be illegal under many countries’ local laws. In response to these concerns, the US Treasury released a joint statement with the governments of the UK, France, Germany, Italy and Spain simultaneously with the release of the proposed regulations announcing an intergovernmental framework for FATCA implementation and international tax compliance.
Under this approach, these ‘FATCA partner’ countries will enter into agreements with the US to collect information from financial institutions and automatically forward this to the IRS. In exchange, FFIs organised in these jurisdictions will not be subject to withholding under FATCA, required to enter into separate FFI Agreements with the IRS, required to withhold on ‘passthru’ payments to other FFIs organised in FATCA-partner countries, or required to close the accounts of recalcitrant account holders.
Because this should significantly reduce the costs of US tax compliance for entities in these countries, and will allow these partner countries to obtain data about accounts held by their taxpayers in the US, other jurisdictions will have an incentive to enter into such agreements. In fact, the participating countries have committed to working towards adopting FATCA as the template for automatic information exchange for Organisation for Economic Cooperation and Development countries – a leap towards automatic worldwide taxpayer information exchange unimaginable only a few years ago.
FATCA client identification, disclosure may be illegal in many countries
This FATCA-partner framework may also serve as a mechanism for allowing international financial centres, some of whom may not yet have tax information exchange agreements with the US, to participate in lessening the compliance burdens for FFIs based in their jurisdictions.
The proposed regulations ease the compliance burden by providing for a ‘phase-in’ of the information reporting and withholding requirements. In 2014 (for the 2013 calendar year) only the US account holder’s name, address, taxpayer identification number, account number and account balance must be reported. Beginning in 2016 (for the 2015 calendar year) reporting on income will be required, and beginning in 2017 (for the 2016 calendar year) gross proceeds must be reported. Withholding will not be required on foreign ‘passthru’ payments until 1 January 2017. However, participating FFIs will be required to annually report the aggregate amount of certain payments to each non-participating FFI.
Although the statute requires that every member of an FFI’s expanded affiliated group also be a participating FFI, the proposed regulations allow a two-year transition period, until 1 January 2016. Until then, a participating FFI may have affiliates or branches in jurisdictions that prohibit reporting to the IRS provided that such affiliates or branches agree to perform due diligence to identify US accounts, retain certain records, and not open accounts that would be US accounts or accounts for non-participating FFIs. Such affiliates would be treated separately for US withholding tax purposes and would be required to identify themselves as non-participating FFIs.
The statute provided that no withholding would be required with respect to payments under any obligation (e.g. debt, life insurance, annuities and derivative contracts) outstanding on 18 March 2012 (grandfathered obligations). The proposed regulations have expanded the scope of this exemption, and will not require withholding with respect to payments under any obligation outstanding on 1 January 2013.
Although the proposed regulations contain a number of provisions that should reduce compliance burdens when compared with prior guidance, trust companies will have to undertake significant work in classifying their trusts under US tax principles and determine how best to take advantage of the owner-documented FFI exception that avoids the otherwise applicable requirement for individual trusts to enter into separate FFI agreements with the IRS.
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