Complying with FATCA

Smart companies are wasting no time in getting ahead of the compliance nightmare known as the Foreign Account Tax Compliance Act (FATCA). Nicknamed ‘Fat Cat’, it was enacted in 2010 to crack down on tax cheats who use offshore accounts and foreign bank secrecy laws to avoid giving Uncle Sam his fair share of taxes on their income.

FATCA hopes to improve tax compliance for financial assets held by US citizens in bank accounts and other vehicles outside the country. Under FATCA, all financial institutions – US-domestic and foreign – must classify account holders as either US or non-US-based, and foreign financial institutions (FFIs) are expected to identify US account holders and disclose their balances, receipts and withdrawals to the IRS. FATCA requires that US withholding agents withhold tax at the rate of 30 percent from all passive payments, such as interest and dividends, paid to a foreign recipient. It will have a significant effect on two classes of companies: US financial institutions, and US companies that make payments to foreign entities.

Some of the requirements of FATCA begin on January 1, 2013, and not many companies are ready or enthusiastic about complying.

‘FATCA is a shotgun approach to ferret out recalcitrant US owners of foreign accounts,’ says attorney Jacob Stein of Klueger & Stein in Encino, California. ‘Any US company that makes payments to a foreign financial institution on account of a US security is now an unwilling participant.’

The high price of FATCA

The banking industry conservatively estimates that it will cost each foreign bank with more than 25 million accounts about $250 million to sift through those accounts and identify those that are held by Americans. The price tag for the top 30 foreign banks could be $7.5 billion, says James George Jatras, principal with Washington-based government relations firm Squire Sanders Public Advocacy. Jatras, who also manages RepealFATCA.com, complains: ‘The compliance tab alone, for any large bank, could be millions, if not tens of millions of dollars in compliance costs – quite a hammer to drop for less than $1 billion in ‘recovered’ revenue yearly, enough to run the government for about two hours.’

While the brunt of FATCA will fall on multi-jurisdictional, large financial institutions, as well as those financial institutions that have not had to consider or comply with US information reporting in the past (like insurance companies and investment funds), FATCA’s reach is broad. ‘A US manufacturing company owned in part or whole by an offshore hedge fund or private equity fund will need to be concerned about FATCA,’ explains Charles Kolstad, of counsel at the law firm of Venable in Los Angeles. ‘That offshore hedge fund or private equity fund will constitute a non-financial foreign entity [NFFE], and thus the manufacturing company will need to collect the FATCA paperwork before making any interest or dividend payments to that offshore hedge fund or private equity fund.’

In a recent survey by Thomson Reuters, compliance professionals around the world reported major gaps in their readiness for FATCA. Over half of the 200 surveyed compliance, risk, audit and legal practitioners from firms across Europe, the Americas, Australia, Asia, Africa and the Middle East said they were unsure of the impact that the new FATCA requirements would have on their companies. More than 40 percent were unsure of their strategic approach for FATCA compliance, and for firms with a US legal entity in the group, 51 percent were unsure of what approach to take in relation to US customers. Over a third said that FATCA had only been discussed once or never at all at the board level. Overall, 59 percent said they are expecting the new requirements to have some impact on their bottom lines, yet nearly 60 percent of firms said no separate or specific budget has been allocated to resource their preparation for FATCA.

Challenges to compliance

In a recent survey by KPMG, 31 percent of respondents with US-based banks and 30 percent of those with foreign banks said that account identification requirements pose the biggest compliance challenge for their institutions. Reporting requirements were the second biggest headache. When asked to identify the largest unresolved area of FATCA compliance for the industry, 32 percent of those with US-based banks and 49 percent of those with foreign banks cited pass-through payments. Second on the list was account identification requirements (22 percent for both groups).

FATCA poses considerable challenges to US companies, which are the most frequent payers of US source amounts and which are required to withhold FATCA tax on payments to ‘non-participating’ FFIs and generally to report the number of payments to FFIs. David Moldenhauer, a partner in the US tax practice of law firm Clifford Chance in New York, notes: ‘Those challenges are particularly exacerbated by the large categories of FFIs that qualify for special treatment under FATCA, and the documentation requirements for establishing the identity and status of such institutions.’

In order to implement the requirements, withholding agents must install robust systems to identify taxable payments, identify and categorize foreign payees, withhold payments to certain payees and report payments to the IRS. Those systems are analogous to the existing foreign payments tax withholding system, but require much more detailed information about the payees to determine and definitively establish their classification, says Moldenhauer.

In addition, FATCA requires US payers and participating FFIs to identify the ‘substantial’ indirect US owners of non-financial foreign entities (NFFEs). ‘Those requirements create challenges for payers to such entities and for the NFFEs themselves,’ explains Moldenhauer. ‘The payers must identify and classify NFFEs, request beneficial documentation, report the substantial US owners, and withhold tax in certain circumstances. The NFFEs must identify their beneficial owners and gather the relevant information for delivery to the payers. This may require the NFFEs to look through intermediate tiers of entities over which they have little influence.’

Some companies will need to re-examine and perhaps renegotiate or redesign agreements with vendors, external service providers and employees, and this will have a significant cross-departmental operational impact during the initial phase of compliance. Theodore Ahlgren, an international tax attorney with Withers Bergman in New Haven, Connecticut, explains that there will be ongoing costs of compliance, as companies will need to track and update these relationships on a continuing basis to ensure that an entity’s FATCA status has not changed. Foreign companies which are an FFI or an NFFE but do not comply with FATCA can be subject to a 30 percent US withholding tax on any dividends and interests they receive from US payers, says Kolstad.

The to-do list is exhaustive, comprehensive and expensive. ‘This is a big deal for companies, especially financial services companies, because the expenses it will require for compliance are dead-weight costs with no discernible benefit to the companies and are potentially significant enough to have a noticeable impact on financial results. This is no trivial undertaking,’ says David Rosenbloom, an international tax attorney with Caplin & Drysdale in Washington.

Take action now

Unfortunately, FATCA comes with even greater uncertainty because the rules are not yet final. ‘The possibility of having different FATCA rules and definitions depending on the jurisdiction is a reality,’ warns Jennifer Sponzilli, a partner with KPMG in New York. While many banks, insurers and investment management companies are waiting to see the final rules, Sponzilli cautions, ‘It’s a big mistake to wait for the rules to be finalized before taking action.’

An 11th-hour rush through the changes necessary to be compliant will only up the price tag – experts say action is required now. ‘You cannot expect to design and implement FATCA compliance overnight,’ says Ahlgren.

Start by understanding the proposed FATCA regulations and intergovernmental agreements. Understand your own status under FATCA and the obligations it imposes on you. ‘Apply those rules to your business value chain,’ says Sponzilli. ‘Take an inventory of legal entities, products, payments, account holders/investors/policy holders/counterparties, distributors and other service providers, systems, processes and controls.’

Consider the people from whom you receive payments and to whom you make payments, and what requirements may apply to them, advises Moldenhauer.

Mark Luscombe, a principal analyst with CCH, which specializes in taxes, advises FFIs to start implementing systems to collect the following information on US accounts:

• Name, address and Taxpayer Identification Number (TIN) of each account holder who is a US person
• If the account holder is a US-owned foreign entity, the name, address and TIN of each substantial US owner of the entity
• The account number
• The account balance
• Gross dividends, interest and other income paid or credited to the account.

Experts also say companies should do a broad review of the gap between the current state of their inventories and what the future state might look like under FATCA, and should estimate the costs of closing that gap (in terms of both effort and risk).

There are a number of other steps companies can take to stay ahead of FATCA:

Think comprehensively. ‘Companies should also be wary of other issues that may arise that are not directly related to the entity’s status as either a payer or recipient of US source payments,’ says Ahlgren. ‘FATCA issues could arise, for instance, in relation to non-US pension plans or life insurance arrangements maintained for the benefit of employees. The company’s FATCA compliance officer will also need to evaluate these relationships, coordinating any necessary response with HR where appropriate.’

Take the FATCA compliance test. Finomial, a software company specializing in FATCA compliance, suggests some key questions that you should have answers to. Do you have a plan for FATCA compliance? Have you identified investors that you need to engage for FATCA compliance? Do you have a FATCA screening process? Do you know what data you need from investors for FATCA compliance? Do you have an approach for tracking your efforts to collect investor information so that you have a full audit trail for FATCA compliance? Have you examined your alternatives for FATCA compliance?

Get vocal. Consider lobbying to modify the rules to reduce significant risk or cost items, either locally or with the IRS or US Treasury. ‘The costs of mounting a broad anti-FATCA education and lobbying program on behalf of US and non-US industry are miniscule compared to the anticipated compliance costs,’ says Jatras.

Says Moldenhauer, soberly: ‘Recognize that FATCA represents a sea change in tax compliance, and versions of FATCA will eventually be adopted by many countries. It’s important that your FATCA systems be robust and that you ensure commitment throughout the company to implementing those systems on a timely basis.’