The Foreign Account Tax Compliance Act (FATCA) is part of a broad initiative by the United States to combat offshore tax evasion by U.S. taxpayers. The goal of the law is not to increase revenues for the U.S. Treasury, but rather to collect information on U.S. taxpayers that invest in foreign financial institutions and foreign entities. However, Treasury regulations have effectively extended FATCA’s reach to many foreign entities investing in U.S. financial institutions that are ultimately owned by foreigners.
Foreigners may not realize that using certain foreign entities (i.e., “personal investment company”) or foreign trusts as an investment vehicle may subject them to reporting requirements under FATCA, and that there are penalties for not complying with those requirements.
FATCA requires a U.S. withholding agent (generally defined as any U.S. party that is making a payment of interest, dividends, certain capital gains, etc.) to withhold 30% of a payment made to certain foreign entities. This withholding, commonly referred to as Chapter 4 withholding, is separate from the withholding that the United States imposes on certain types of income payable to foreigners, which is referred to as Chapter 3 withholding.
A foreign entity includes entities that are treated as corporations for U.S. tax purposes such as Limited Companies, Sociedad Anónimas, Sociedads de Responsabilidad Limitadas, and Limitadas. A foreign entity for FATCA reporting purposes also includes certain foreign trusts that would usually not be considered foreign entities under U.S. tax law.
The most common withholding under FATCA applies in the situation where a foreign entity meets the definition of a foreign financial institution (FFI) and receives income that would not be subject to U.S. withholding tax under Chapter 3. An FFI includes depository institutions (i.e., banks), custodial institutions (i.e., brokers), investment entities, specified insurance companies, certain holding companies, and certain treasury centers.
To avoid Chapter 4 withholding, the recipient FFI must generally agree to annually disclose information about accounts held by U.S. persons or 10% U.S.-owned foreign entities and to follow certain verification and due diligence procedures with respect to these accounts. An FFI will have an obligation to register with the Internal Revenue Service and obtain a FATCA number known as a global intermediary identification number (GIIN), and thereafter submit certain reporting information.
How information must be reported to the U.S. government depends on whether the country where the FFI is organized has entered into an intergovernmental agreement (IGA) with the United States. If the FFI’s home country has entered into a Model 1 IGA, the FFI can annually report required information to its home country’s government, which would subsequently forward the information to the IRS. If it is not organized in a Model 1 IGA jurisdiction, the FFI must submit this information directly to the IRS.
Implications for Foreigner Investors and FFIs