ABBL

FATCA - what is it good for?

The US HIRE Act provides for a number of measures aiming at maintaining and creating jobs in the USA. The sources of funding to be used to finance the job creation measures are to be found under the FATCA (Foreign Account Tax Compliance Act) section of the HIRE Act. FATCA, which will become applicable as of 1 January 2013, primarily deals with tax compliance obligations of US investors with foreign accounts, reporting obligations by US taxpayers as well as with anti-abuse measures in relation to lending and repurchase transactions. It aims at ensuring that all US taxpayers with accounts abroad and using foreign entities are reporting their foreign earned income and paying their taxes in the USA according to US tax rules.

FATCA introduces reporting obligations by foreign financial intermediaries (FFI) on US accountholders and certain US investors. It further introduces penalties applicable to FFIs that do not enter into an agreement with Internal Revenue Service (IRS). A new US withholding tax of 30% is applied on interest, dividends and gross sales proceeds (on the capital redeemed or sold) paid to foreign financial intermediaries. FATCA imposes upon FFIs the obligation to apply specific client identification rules that go beyond existing EU and / or domestic anti-money laundering (AML) and know your customer (KYC) rules.

FATCA also imposes an obligation to close accounts held by “recalcitrant” accountholders. Recalcitrant accountholders are clients that do not respect the additional conditions that the US are intending to impose and do not provide the FFI with specific documentation determining their non US status. FATCA imposes upon FFIs an obligation to report the number of recalcitrant accountholders and their assets.

To put it bluntly: FATCA turns foreign financial intermediaries into US tax collectors.

Much ado about a little tax income

For the finance industry outside the US, FATCA indeed represents an exorbitant financial cost, considering the significant investments that have to be made in human resources and IT infrastructure. Ironically, the potential tax income for US Treasury seems fairly negligible. The investments that have to be made are thus entirely disproportionate to the expected returns.
Moreover, while FATCA will only enter into force in January 2013, financial intermediaries need to take important financial, organisational and IT infrastructure decisions now. However, there are currently no implementation guidelines from the US.

Worryingly, FATCA rules are bound to create a number of conflicts with local legislation, such as:

• the obligation to identify, document and screen clients to an extent that goes largely beyond European AML-KYC laws;
• the obligation to report automatically to the IRS on US and also non US clients;
• the obligation to close accounts of US and also non US clients that do not comply with the information requirements;
• the obligation to apply US withholding tax to non US persons under an obscure “pass-thru” concept that transforms non US income into US income;
• the obligation to waive Double Taxation Agreement rights under the concept of “election to be withheld upon”

Too complex for its own good

Due to the great complexity of the provisions, and the perspective of a very weak cost/efficiency relation, the cost of implementing FATCA will considerably erode the taxable income of financial intermediaries, which will in turn have a direct effect on the tax income left for the Treasury of each country in which compliant FFIs operate while not providing any benefit to that country in exchange.

On the other hand, the declared aim of the law to cover as many foreign intermediaries as possible is destined to fail, as the implementation will be too complex and too costly. The important number of FFIs to be controlled by the IRS will considerably increase administrative cost in the US.

The “pass thru” concept will turn non-US source income into US source income and possibly lead to the application of withholding taxes imposed by two different countries to the same income.

The unwieldy and indiscriminate behemoth that is FATCA has triggered and continues to trigger strategic reflections amongst certain European financial intermediaries to refuse to open accounts to any person with an US status and even to completely disinvest from US securities. There is a serious risk that a two-tier system will be created in the world with intermediaries respecting the new rules and others not.

Such an evolution can neither be in the interest of Europe nor of the US.

A note on Notice 2011-34 of the US Treasury:

The recently issued notice 2011-34 clarifies a certain number of points that were left open under the initial notice 2010-60. It provides

• limited (and too restrictive) exceptions from the general requirement that a FFI enter into an FFI agreement to avoid withholding tax
• that QIs (qualified intermediaries) generally will be required to become Participating FFIs
• that an FFI may become a Participating FFI only if all affiliated FFIs become Participating FFIs
• a largely expanded due diligence procedure (covering family members that are not accounts holders) for pre-existing individual accounts that are private banking accounts or have a value exceeding $ 500.000.-
• explanations to the “pass through concept”, which means that

1. a Participating FFI making payments to non-compliant account holders (including non-compliant FFIs) on its own behalf (not as custodian) must withhold tax based on the proportion that the Participating FFIs US assets (securities and others) bears to its total assets
2. a Participating FFI receiving payments from another Participating FFI as a custodian for an non-compliant account holder, the Participating FFI must withhold tax based on the proportion that the lower Participating FFI’s assets bear to its total assets.

Article published in Luxembourg Banking Quarterly 02/2011