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Foreign Account Tax Compliance Act threatens investment in the U.S.

By: Christopher Elias

Source: blog.reuters.com | Financial Regulatory Forum


(The views expressed are the author’s own)
LONDON/NEW YORK, (Business Law Currents) – A fiscal tourniquet will put a squeeze on tax evasion – the Foreign Account Tax Compliance Act (FATCA) is threatening to clog the arteries of the world’s financial system with U.S. withholding taxes and burdensome obligations on non-U.S. firms.

Designed to staunch the bleeding of capital from the U.S. to secret bank accounts, FATCA is clamping down on overseas earnings but its unintended consequences are threatening to undermine investment in the U.S.

Buried within the $17.5 billion Hiring Incentives to Restore Employment (HIRE) Act, the Foreign Account Tax Compliance Act of 2009 (FATCA) was signed into law on 18 March 2010- a prosaically named act with potentially calamitous consequences.

With substantial extraterritorial effect it will make financial institutions the world over U.S. Treasury watchdogs – tracking and recording the flow of U.S. source income irrespective of location. It also has the potential to impinge upon a wide range of transactions (e.g. derivatives) which have no ostensible connection to the U.S. at all.


At its heart FATCA is about disclosure. Its aim is to uncover the perceived tax abuse by U.S. persons of off-shore financial accounts. Designed to reveal the existence of U.S. money held offshore, it seeks to crack down on undisclosed earnings by U.S. tax payers at any cost.

Under FATCA’s provisions, foreign firms are required to provide the IRS with details of all U.S. persons who have foreign holdings of more than $50,000. If they fail to do so then foreign firms face a punitive 30% withholding tax on all U.S. income they receive.

Projected to recoup $8 billion of lost tax revenue the economic burden of the act falls squarely on the shoulders of foreign financial institutions (FFIs) and the costs are substantial. Crossbridge, a London-based consultancy for the investment banking industry, estimated recently that compliance costs may be between US$150 million to $200 million for every medium sized bank.

These enormous costs arise from the extensive obligations placed on foreign financial institutions. FATCA requires a FFI to track and identify all U.S. money on behalf of the IRS. This includes ascertaining and disclosing to the IRS the:

name, address and Tax Identification Number (TIN) of each account holder that is a U.S. person;
name, address and TIN of each substantial U.S. owner of any account held by a U.S. owned foreign entity;
account number;
account balance or value; and
gross receipts and withdrawals/payments from the account.
Substantial U.S. owners of foreign entities include any U.S. person who owns directly or indirectly more than 10% beneficial interest in a company, partnership or trust.

As FFIs are outside of the IRS’s jurisdiction compliance is voluntary, although the IRS is giving FFIs more than a little incentive to comply. If a firm fails to comply with the IRS’s disclosure requirements then it will be subjected to a withholding tax of 30 per cent on all U.S. source income. This includes bank deposit interest and the gross proceeds from the sale of U.S. assets.

FFIs will also be encouraged to help “incentivize” other FFIs. Under FATCA, participating FFIs will be required to impose a 30% withholding tax on any payment to a non-participating FFI.


The definition of “FFI” is incredibly broad and catches more than just banks, brokers and custodians. Also falling within the remit of the act are hedge funds, insurance companies, mutual funds, private equity funds and real estate companies.

Under FATCA a FFI includes any non-U.S. entity that:

accepts deposits
holds financial assets for the account of others; or
engages primarily in the business of investing or trading securities, commodities, partnerships, or any interests in such positions.
The combination of a wide definition of FFI and the scope of what is considered a U.S. “person” places a substantial burden on foreign financial institutions to track, monitor and report U.S. foreign holdings.

Caisse Centrale Desjardins, the Canadian cooperative bank, noted some of the potential impacts of FATCA in its recent €7 billion global medium term note programme. Caisse Centrale Desjardins notes:

“A withholding tax may also be imposed under FATCA on certain payments made by FFIs that have opted into the regime to (a) other FFIs that have not opted into the regime (as described in the paragraph above) or (b) certain non-FFIs that do not provide adequate information to the IRS on their U.S. account holders. Pursuant to these rules, a withholding tax may be imposed on a portion of payments to holders of Notes if the Issuer opts into the regime, derives U.S. source income or disposition proceeds from the sale of assets that give rise to U.S. source dividend or interest income, and either (x) the holder of the Note is an FFI that has not opted into the regime or (y) the holder of the Note is not an FFI, but the Issuer is unable to obtain the necessary information from such holder to enable the Issuer to comply with its obligations under the regime.”

As a result of this withholding tax Caisse Centrale Desjardins notes that payments to noteholders will have no “gross up”, meaning that payments to noteholders will be reduced by the amount of any withholding tax levied.

Caisse Centrale Desjardins also drew attention to the fact that significant uncertainty remains over just how far reaching these regulations are. According to the same filing:

“The future application of FATCA to the Issuer and the holders of Notes is uncertain, and it is not clear at this time what actions, if any, will be required to minimize any adverse impact of FATCA on the Issuer or the holders of Notes. Furthermore, it is uncertain at this time how the requirement that FFIs enter into an agreement with the IRS to opt into the regime will apply to Notes held through DTC, Euroclear, Clearstream, Luxembourg and other similar clearing systems. If such clearing systems are not exempted from the FATCA regime, those clearing systems would likely need to take significant operational steps to acquire and report the required information from their account holders.”


Another problem identified by a number of issuers is the risk that one non-participating FFI in a series of transactions could cause other FFIs to incur 30% withholding tax. The presence of a single non-participating FFI in a payment chain can mean that the ultimate beneficiary incurs significant tax losses.

Under FACTA, if a FFI agrees to the IRS’s terms (“a participating FFI”) then it will be under an obligation to deduct 30% withholding tax for any payment relating to U.S. assets to a FFI that has not agreed to participate with the IRS’s demands (“a non-participating FFI”).

The interconnected nature of the financial world means that often transactions involve multiple counterparties. This presents difficulties under the FATCA regime on a number of fronts.

To begin with, FFIs will need to be able to identify whether other institutions in a chain are participating or non-participating FFIs. Where an FFI is non-participating a 30% withholding tax deduction will need to be made. This will require substantially more information on the identity of counterparties than is currently the standard practice. It will also be necessary for FFI’s to track what is and what isn’t U.S. source income. This presents difficulties where assets are being swapped or where the ultimate beneficiary of a fund is unclear.

The transactions will also have to adjust to allow for the potential that one non-participating FFI may have on other parties in a payment chain. FFIs may wish to incorporate termination provisions for non-compliance and may also wish to deal with withholding tax inadvertently falling due.

The impact of this on bond holders was noted by Emporiki Group Finance plc

“The application of FATCA to interest, principal or other amounts paid with respect to the Notes is not entirely clear. If an amount in respect of U.S. withholding tax is deducted or withheld from interest, principal or other payments on the Notes as a result of a holder’s failure to comply with these rules or as a result of the presence in the payment chain of a non-participating FFI, the terms of the Notes will not require any person to pay additional amounts as a result of the deduction or withholding of such tax. As a result, investors may, if FATCA is implemented as currently proposed by the IRS, receive less interest or principal than expected. Holders of Notes should consult their own tax advisers on how these rules may apply to payments they receive under the Notes”

A payment flow between otherwise participating FFIs could therefore be broken by one non-participating FFI, resulting in a 30% loss. Whilst this might encourage some to become FFIs it may also have the reverse effect by incentivizing those with little connection to the U.S. to avoid participating-FFIs for fear of the tax consequences. This is particularly so where it is difficult for a fund to comply with FATCA requirements because it does not have the necessary information to report to the IRS.

For example, where a FFI cannot identify the ultimate identity of an investor it may have no choice but to become a non-participating FFI and therefore stay clear of U.S. investment. Umbrella funds are likely to have particular difficulty in identifying whether income is from a U.S. source, as they have little contact with the ultimate beneficiary.


A further complication is contained in what has been termed “passthru payments”. According to recently released IRS definitions, a portion of any payment made by a FFI will be treated as a passthru payment, and therefore subject to 30% withholding, in proportion to the ratio of the FFI’s U.S. assets to its total assets (the passthru percentage).

As the International Swaps and Derivatives Association (ISDA) notes in its recent FATCA alert

“the passthru payment rules could potentially impose US withholding tax on an interest payment made by a British Bank’s London office to a German Bank’s Frankfurt office if the German Bank is a nonparticipating FFI and the British Bank is a participating FFI, provided the British Bank holds any US assets in any of its global offices. The FATCA withholding rate in such case is 30% times the passthru payment percentage of the British Bank. The passthru payment percentage is expected to be calculated at least annually by dividing an FFI’s Total US Assets by the FFI’s Total Assets (in each case determined on a global basis).”


FATCA will also impinge upon derivative transactions. ISDA announced recently that it had amended the definition of “Indemnifiable Tax” in the ISDA Master Agreement in order to carve out FATCA withholding tax. The change means that gross-up provisions requiring a party to pay sums without deduction for withholding taxes do not extend to withholding taxes charged pursuant to FATCA.

The impact of the change is to place the withholding tax burden on the recipient of the payment. The rationale being that “the recipient is the sole party that has the ability to avoid the withholding tax by complying with the FATCA rules”.

ISDA also recommended adding a number of additional FATCA related provisions to its standard contracts. For example, ISDA suggested including formal document delivery provisions so that a FFI can determine whether a party is FATCA compliant. Parties may also wish to require a confirmation that no more than 10% of a company is owned by a U.S. person and to add termination rights for if withholding tax becomes due.


In keeping with the extraterritorial effect of the act, under FATCA where foreign laws conflict with its provisions, then the FFI must attempt to obtain a waiver of such law from the respective account holder. If a waiver is not obtained within a reasonable period of time, then the FFI must close the account.

This provision has little regard for other legal systems and may prove extremely problematic. A FFI will likely be juggling the requirements of multiple jurisdictions, some of which may not allow the FFI to unilaterally close an account. Further, some deal structures (eg Private Equity) do not allow for a client’s interest to be redeemed without certain conditions being met. It may be virtually impossible therefore for a FFI to redeem a client’s interest and close the account.

As firms await final regulations clarifying the small print of FATCA, time is running out for compliance. FATCA is due to be in force from 2013 and yet significant uncertainty remains as to whether there will be any exemptions from its broad provisions.

With foreign financial institutions frantically reviewing their exposure under the new act, significant change will be required for anti-money laundering (AML), know-your-client (KYC) and reporting procedures to comply with the rules. Much work remains to be done and many may conclude that it simply isn’t worth the cost. Those that come to this conclusion will likely be forced to exclude U.S. customers and participating FFIs from transactions – a bifurcation of the financial system that could see a further bleeding of funds from the U.S. financial system.


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