New US tax rules will affect the offshore financial industry

Recently, the offshore investment community has received significant increased attention from the United States as a potential source of tax evasion.  As a result, the United States has enacted into law the Hiring Incentives to Restore Employment Act of 2010.  As adopted, the HIRE Act includes a slightly modified version of another previously proposed bill, called the Foreign Account Tax Compliance Act of 2009, which adds new sections 1471 through 1474 to the US Internal Revenue Code, writes Jonathan Treadway, tax senior manager and Anthony Fantasia , tax director, both with Deloitte.

This provision in the HIRE Act is intended to close perceived gaps in information reporting to the Internal Revenue Service and curb abuses relating to the use of offshore accounts by US taxpayers.  FATCA is expected to result in a widespread impact on the offshore investment community both before and after the effective date of the legislation.

Generally speaking, FATCA will implement a new 30 per cent withholding tax on “withholdable payments” made after December 31, 2012 to a “foreign financial institution”, unless certain requirements are met.  Under the new law, an FFI is broadly defined to include all non-US banks, asset custodians, and investment funds.  A “withholdable payment” generally includes

(i) any US sourced payment – e.g., interest, dividends, rents, compensation – and
(ii) the gross proceeds from the sale of any asset that could produce US sourced dividends or interest.  Since virtually all US sourced payments to offshore financial institutions will therefore be within the scope of FATCA – whether or not any portion of a payment is allocable to a US person – it is critical that offshore banks, custodians, and investment funds understand what steps they can take to avoid the new 30 per cent withholding tax.

Thus far, the HIRE Act and subsequent initial guidance provided by the US Department of Treasury and IRS have carved out very few exceptions from the FATCA rules.  It is anticipated that despite comments from various industry groups seeking exceptions to put hedge funds and other foreign entities outside of FATCA’s scope, FATCA will continue to have broad application.  As a result, it is expected that most FFI’s will attempt to avoid imposition of the new 30 per cent withholding tax by entering into and complying with an “FFI agreement.”

In general, entering into an FFI agreement with the IRS will require the FFI to

(i) collect sufficient information on all of its account holders to enable the FFI to determine whether the account holder is US or foreign,

(ii) report information about US accounts to the IRS annually,

(iii) withhold 30 per cent of withholdable payments made to the FFI that are allocable to account holders that fail to comply with reasonable requests for identifying information (“recalcitrant account holders”) or non-compliant FFI’s,

(iv) close any accounts where identifying information about the owner of the account cannot be obtained within a reasonable period of time, and

(v) comply with IRS requests for additional information about any US account.  In a chain of ownership that includes multiple FFI’s, each FFI in the chain generally must enter into and comply with an FFI agreement in order to avoid application of the new 30 per cent withholding tax upon pass through of any payment to an upper-tier FFI.  Additionally, each FFI in a chain of ownership is considered to be a withholding agent potentially liable for collecting and remitting the 30 per cent withholding tax.

It is anticipated that the FFI agreement will contain standard terms for all FFI’s, and that new IRS forms will be issued that will update existing forms related to the current US withholding tax rules; it is likely that these forms, along with final regulations on FATCA, will be issued by the IRS sometime in 2011.  As a result, there will be much additional guidance to digest before FATCA will be required to be implemented with respect to “withholdable payments” beginning January 1, 2013. 

However, for offshore investment community participants, the broad scope of FATCA necessitates that planning take place now, in order to avoid the detrimental new 30 per cent withholding tax upon FATCA’s implementation.

In order to meet the documentation, withholding, and reporting requirements of FATCA, participating FFI’s will need to make significant changes to a wide range of processes and systems, including procedures for existing and new accounts, marketing and client interaction, tax reporting and remitting, information technology systems, and legal/privacy controls.  With 2013 approaching, FFI’s and offshore fund service providers should consider:   

  • Planning and establishing a program management team and governance structure for implementing the required changes;
  • Documenting systems, data, and processes impacted;
  • Assessing current systems and identifying necessary systems enhancements;
  • Conducting a risk assessment and gap analysis on existing compliance, operations, and technology processes and systems, to assist in determining (i) what additional information will be required from client account holders and investors, (ii) how that information will be collected and stored, and (iii) record-keeping and other capabilities for withholding tax and reporting information to the IRS under an FFI agreement;
  • Developing a communication plan for business units impacted by FATCA;

Most importantly, FFI’s and offshore fund service providers should embrace FATCA compliance at the executive level, and involve qualified tax and systems technology professionals to provide the best chance of successful compliance with this new and far-reaching piece of US legislation.