Foreign Account Tax Compliance Act: U.S. payors need to act now to avoid taxation later
U.S. taxpayers making “withholdable payments” abroad to foreign entities, absent taking preparatory steps, could soon see their U.S. tax liability dramatically increase. In March of 2010, in an effort to reduce the ability of U.S. taxpayers to hide income overseas, Congress passed the Foreign Account Tax Compliance Act (FATCA). FATCA establishes a comprehensive information reporting and withholding regime that empowers the Internal Revenue Service (the Service) to monitor and collect tax on U.S. source payments made to foreign entities that have U.S. account holders. For the last two years, the lack of cohesive guidance from the Treasury Department gave hope to financial institutions and multinational corporations in both the U.S. and abroad that the arduous reporting obligations imposed by FATCA would be repealed. Proposed regulations released earlier in 2012 make certain that FATCA is entrenched in the U.S. tax code. Unfortunately, the burden of tax collection under the act is placed on withholding agents, which are most frequently the U.S. payors.
Nuts and bolts
Pursuant to FATCA, “withholding agents” must withhold 30 percent of any withholdable payments made to foreign financial institutions (FFIs) that do not agree to share information with the Service regarding their U.S. account holders (nonparticipating FFIs). Furthermore, withholding agents must withhold on withholdable payments to non-financial foreign entities (NFFE) that fail to certify that they do not have any substantial U.S. owners or, alternatively, do not provide information regarding their substantial U.S. owners (noncompliant NFFE).
The definition of withholding agent is quite broad and includes U.S. financial institutions, U.S. multinational institutions, U.S. investment funds, and any other U.S. taxpayer that controls or makes any withholdable payment abroad (collectively “U.S. withholding agents”). Failure to withhold will subject withholding agents to tax liability both for the under withheld tax as well as related penalties and interest that may be assessed as a result of the failure. The breadth of FATCA and the subsequent proposed regulations leave certain that to varying degrees, U.S. withholding agents will have to adjust their current practices to avoid tax liability for failure to withhold and remit taxes to the Service.
The definition of withholdable payments is also broad and includes any payments of U.S. source fixed or determinable, annual or periodical income (known as FDAP under existing law), as well as U.S. source gross proceeds from the sale of stock, securities, and other debt instruments. Among other things, FDAP includes interest (without an exclusion for portfolio interest or bank deposit interest), original issue discount (OID), dividends, rents, royalties, compensation for services, prizes or awards, scholarships, pensions and annuities, and commissions and fees. For example, if a U.S. company pays royalties to a non-U.S. entity for technology or other property licensed for use in the U.S., or pays fees to a non-U.S. entity for individuals performing services in the U.S., such payments could be withholdable payments, if the non-U.S. entity (an NFFE) is not treated as in an active business under IRS guidance.
The effective dates of FATCA will be phased in over the next few years. A withholding agent may be subject to a 30% U.S. withholding tax imposed on its share of payments of (1) U.S.-sourced dividends, interest, royalties, and other types of FDAP on and after January 1, 2014, and (2) gross proceeds from the sale or other disposition of U.S. stocks, securities, and other debt instruments on and after January 1, 2015.
The sting of FATCA is mitigated to the extent that U.S. withholding agents adequately monitor their activities and ensure that payments subject to FATCA are being withheld upon unless the foreign recipient provides the requisite documentation to the withholding agent. Once fully implemented, U.S. withholding agents must have processes in place that do the following:
- Identify payments made to foreign entities
- Characterize these payments to determine if they are withholdable payments subject to FATCA
- Characterize the foreign entity as an FFI or an NFFE
- Determine whether the foreign entity is a nonparticipating FFI or a noncompliant NFFE
- Determine whether the recipient of the payment, the foreign entity, is also the beneficial owner of the payment
- Determine if an exception exists to avoid withholding under the statute or IRS guidance
- Withhold on payments to nonparticipating FFIs, non-withholding participating FFIs, and noncompliant NFFEs beginning January 1, 2014 (or January 1, 2015 for applicable gross payments)
- Obtain adequate documentation from participating FFIs and compliant NFFEs to justify the decision not to withhold on the payment
U.S. payors familiar with the domestic backup withholding provisions are often surprised by the inflexible approach taken by the Service with respect to payments directed abroad. The Service has less control over payments to non-U.S. recipients and to offset its lack of control, it has constructed an inflexible withholding regime that imposes significant compliance hurdles on U.S. payors. Fortunately, similar to other information reporting provisions in the Internal Revenue Code, FATCA is largely an exercise in administrative diligence.
We recommend that our clients take a measured approach to FATCA, but not to delay consideration of it. Today, it is important to analyze your payment streams and determine the extent to which you will be impacted by FATCA. Once you have properly characterized the impact, it is necessary to determine the degree to which your operations must be adjusted to facilitate future compliance. For the majority of our clients, the “shock and awe” approach suggested by some other law firms and large accounting firms may not be necessary—slight modifications to existing foreign withholding procedures will be sufficient. For others, a more comprehensive approach is inevitable.
- Although usually the case, the withholding agent is not necessarily a U.S. payor. For example, unless it elects otherwise, an FFI that has agreed to share information with the Service is the withholding agent when it receives a “passthru payment” on behalf of a recalcitrant account holder or another FFI or NFFE that has not entered into the requisite agreements with the Service.
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