Highly indebted advanced nations are taking aim at wealthy tax evaders. Governments, keen to reduce their budget deficits, are determined that the rich pay their fair share. According to a former chief economist at McKinsey & Co, as much as $ 21 trillion is hiding in secret tax havens, resulting in $ 280 billion of annual lost tax revenue. To help close that “black hole”, the U.S. Congress enacted the Hiring Incentives to Restore Employment Act of 2010, which includes a revised version of a bill introduced in 2009 called the Foreign Account Tax Compliance Act.
This legislation takes aim at a key link in the chain of those thought to be aiding the wealthy in their nefarious pursuit — the foreign financial institutions. The legislation is both broad in scope and global in impact. Known as FATCA, the law is to be phased in over the next five years or so. This primer will give you some insights into the new legislation, which is still very much a work-in-progress.
FATCA is the Foreign Account Tax Compliance Act. It indirectly targets U.S. Persons that use offshore accounts to evade taxes. By “U.S. Persons”, we mean American citizens and Green card holders, those who are required to pay U.S. taxes on their worldwide income.
FATCA obligates foreign financial institutions (FFIs) to identify, report, and collect withholding taxes from individual account holders.
FFIs are broadly defined by FATCA as foreign entities that either directly accept deposits or manage the financial accounts of others. They include foreign banks, security houses, insurance companies, asset management firms and other like institutions.
FATCA legislation becomes effective on 1 January 2013. Penalties associated with non-compliance do not start until 1 January 2014. After that, there is a phased approach to enactment. The IRS wants to give the financial industry time to understand and comply with the law. FFIs need time to upgrade computer systems able to identify and report account holders of U.S. personage, apply withholding tax where applicable, and make the appropriate remittances to the IRS. In many instances, FFIs are only beginning to look in earnest at how to manage the new legislation. The IRS has responded by extending the time frame until full enactment. The more onerous penalties associated with the hardest parts of the legislation to comply with do not kick in until 2017 at the earliest.
So what is FATCA and how, under the current proposal, is it supposed to work?
FATCA is designed to induce U.S. Persons to correctly comply with their U.S. tax reporting and payment responsibilities. U.S. Persons that fail to report their foreign income, or that fail to allow FFIs to report their foreign income for them, are subject to a withholding tax. It does so by encouraging FFIs to become “participating FFIs” who then act as the long arm of the IRS. An FFI is considered to be a participating FFI when it agrees to comply with the terms of FATCA by entering into an agreement with the IRS. A participating FFI is obliged to provide the IRS with information about its account holders, which can then be used to cross-check against other information sources to prevent tax evasion. Any individual who refuses to provide a participating FFI with information intended to reveal their status as a U.S. Person, would be deemed “recalcitrant”. A recalcitrant is subject to a 30% withholding tax on their U.S. source income, defined broadly as income that can either directly or indirectly be traced back to having its origins from sources within the U.S. That includes proceeds from the disposing of debt or equity and the payment of interest, dividends, income, gains, salaries and fees.
Any FFI that fails to become a participating FFI will find that they too will be subject to the 30% withholding tax. I’ll show you how this works, but first a word about this tax. In practice, it is not so much a withholding tax as it is a “severe penalty”. Ordinarily, withholding tax may be refunded when a taxpayer files his tax return. Not so with FATCA’s withholding tax, which may not be refundable depending upon the situation. Also under FATCA, where there is trading activity, for instance when buying and selling stocks, the tax is not just on the gain component, but rather on the total purchase or sale price. Principal gets wacked by a 30% tax on gross amounts traded. Such onerous penalties place FFIs between a rock and a hard place. Unless an FFI chooses not to deal with U.S. Persons, they will have little option other than to enter into an FFI agreement with the IRS to avoid the onerous tax.
Here is an example of how FATCA is intended to work under current proposals. Assume you, a resident of Japan, ask Osaki Securities (a fictional brokerage house) to buy shares in Microsoft. Assume Osaki must conduct that transaction through a third-party U.S. broker, because either they are not licensed to trade in the United States, or they don’t have operations there. When placing the trade, the third-party U.S. broker is obliged to determine if Osaki is a participating FFI. If it is not, the third-party U.S. broker, to comply with FATCA, would be required to collect a 30% withholding tax on the trade and pass it on to the IRS. If Osaki, on the other hand was a participating FFI, then compliance responsibility under FATCA would pass to Osaki. In that instance, Osaki might need to ask you questions (where there is U.S. indicia) designed to reveal if you were a U.S. Person. If you had answered Osaki’s questions, you would not be subject to a withholding tax. However, if you refused to answer, Osaki would be obliged to collect the 30% tax and pass it to the IRS.
Let’s look at the return on investment for each of the parties in the above example. You bought Microsoft shares for $ 100 through Osaki. The price goes up, and you sell them for $ 101. If you were a recalcitrant because you refused to provide Osaki, a participating FFI, with the information it requested, then the entire $ 101 is subject to a 30% withholding tax (not just the $ 1 gain). So your $100 investment returns only $ 69.7. Instead, if Osaki were a non-participating FFI, the withholding tax and losses would be levied against Osaki (although who would bear that cost – Osaki or you – is a commercial question that remains to be answered). Either way, one party takes a big hit.
Does the IRS really expect Japanese banks, indeed foreign financial institutions worldwide, to ask intrusive questions of their customers simply to weed out the few among them that are tax evasive, U.S. Persons? Apparently, the answer is “Yes”. In various consultation notes prepared by the Japanese Securities Dealer Association, the JSDA commented that, “asking such a delicate and private question is not something Japanese financial institutions could ask to their customers.” They further questioned if Japanese law permitted applying a withholding tax on those recalcitrant. And they questioned if FATCA would be in violation of customers’ property rights under Japanese law. Questions still abound. For instance, where two banks are conducting lending transactions with each other, it remains unclear if FATCA will enforce the 30% withholding tax on principal amounts, not just on interest, dividends and gains. Many fear that applying the tax on principal would wreak havoc on the financial community, given the way international finance operates today.
FATCA also requires a 30% withholding tax on payments to certain non-financial foreign entities, should they choose not to become FATCA compliant. The IRS created this category to prevent U.S. Persons from circumventing the reporting requirement by purposefully making their investments through a foreign company.
FATCA has yet another set of rules to deal with U.S. Persons who purposely set out to avoid transacting with participating FFIs. The so-called “pass-through payment regime” requires participating FFIs to apply a withholding tax on the lateral transactions they conduct with non-participating FFIs. This is how the legislation is supposed to work: Assume CBSH, a fictional Hong Kong bank and participating FFI, transacts with a local bank in Nairobi which has never heard of FATCA and that is not a participating FFI. Also assume the Nairobi bank doesn’t have any assets in the U.S. Unless the Nairobi bank meets some kind of exclusion under FATCA, CBSH must classify it as a non-participating FFI. Under what has become the most controversial piece of FATCA legislation, CBSH may need to apply a 30% withholding tax on pass-through payments to the Nairobi bank based on CBSH’s pass-through payment percentage. The pass-through payment percentage is measured by dividing the sum of the participating FFI’s U.S. assets by its global assets. So if CBSH has 50% of its assets in Hong Kong and 50% of its assets in the U.S., then the 30% withholding tax is imposed on 50% of its payments to the Nairobi bank — the logic being that when you trace the genesis of the payment back, 50% of it was “effectively generated” in the U.S.
Global financial institutions have become very concerned about this piece of the legislation. Even if they wanted to, many global FFIs believe it would be difficult or impossible to accurately determine their firms pass-through payment percentage. For this reason, the IRS has delayed the reporting requirement related to pass-through payments until 2015. Even then, pass-through payment penalties won’t kick in until 2017 at the earliest.
This article was reviewed and edited by one of the ‘big 4’ audit firms. Beacon Reports extends it sincere gratitude for their assistance.