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
The United States has several federal income tax provisions intended to attract foreign capital to U.S. banks, U.S. financial institutions and U.S. businesses. Many foreign individuals and foreign families often structure such U.S. investments through foreign companies, foreign corporations, foreign trusts,and/or a combination thereof for a myriad of reasons, including home country tax benefits, U.S. estate tax minimization, anonymity and estate planning. However, not many foreigners realize that using such a foreign entity or foreign trust may subject them to FATCA.
For example, many foreigners and foreign families use a foreign entity, often referred to as a foreign personal investment company (PIC), as a vehicle to invest in the United States. If that foreign entity opens a portfolio account with a U.S. financial institution and that institution provides investment advice to the foreign entity, the foreign entity could be considered as “managed by another entity” and meet the definition of an Investment Entity and hence an FFI pursuant to Treas. Reg. 1.1471-5(e)(4).
Many foreigners also use a foreign trust to hold underlying subsidiaries and/or accounts that are held in the United States. If the foreign trust has a corporate institution serving as a trustee or co-trustee, that could cause the foreign trust to be treated as an investment entity and hence an FFI. If the foreign trust owns underlying foreign PICs investing with U.S. financial institutions, there may be multi-level FATCA reporting.
Under FATCA, the foreign owners of an FFI are required to annually submit certain information relating to the owners of the FFI. This information must be submitted to the IRS or to the FFI’s home government if the foreign country has entered into an IGA. Failure to adhere to these FATCA provisions and reporting will trigger U.S. withholding tax on payments made to the FFI.
If you are unsure about your or your clients’ reporting obligations under FATCA, consider speaking to a tax professional who specializes in international tax issues. Not complying with FATCA can have significant implications for U.S. taxpayers, foreign financial institutions and foreign investors.
See all three blog posts on FATCA compliance on ThinkAdvisor.