FATCA has been called many things – an affront to sovereignty, a U.S. attempt to outsource taxation, and an awfully big stick with which to prevent just a fraction of American tax evasion, among them. The reality is that it is an effort to prevent tax avoidance by Americans – an effort that is going to cost financial institutions globally up to $40 billion. Moreover, the deadline for compliance is looming, and many institutions are not ready. Oh, and it does not only apply to financial institutions.
The law, which comes into effect on Jan. 1, 2013, has financial institutions in the region up in arms.
“FATCA is an attempt by the U.S. to unilaterally super-impose its tax system – arguably the most complex regime in the world – on all of the world’s financial institutions,” says a joint submission by the Hong Kong Investment Funds Association, the Investment Management Association of Singapore, and the Association of Mutual Funds in India, among others, to the U.S. Internal Revenue Service (IRS) and Treasury Department. It was one of more than 150 submissions the IRS received calling for changes to the Act.
The widely held nature of U.S. securities means that most financial institutions will have to be FATCA-compliant. This means the impact of FATCA is quite significant: Compliance with the Act could cost financial institutions globally anywhere from $30 to $40 billion, according to Charles Kinsley, a principal at KPMG China.
“Many of the major international banks are very focused on FATCA, and aim to be on track for compliance. Unfortunately, many other financial institutions are far from prepared,” says Richard Weisman, head of Baker & McKenzie's Global Tax Practice Group, who has worked as a member of a FATCA working group representing Hong Kong financial services industries. Part of the challenge is that the Act’s final regulations – due to come out this summer – have not been released.
A revamp of the U.S. withholding system
The Act imposes a 30 percent withholding tax on payments to foreign financial institutions (FFIs) and non-financial foreign entities (NFFEs) that are not FATCA-compliant.
To comply, FFIs must enter an agreement with the IRS to identify and disclose U.S. persons who are account holders, “follow due diligence rules and withhold on ‘recalcitrant account holders’. NFFEs must disclose any U.S. persons who own more than 10 percent of the NFFE, directly or indirectly”, according to information posted on the website of U.S.-based taxation law firm Burt, Staples & Maner, LLP (BSM). Any U.S. source income or “proceeds from the sale of securities that theoretically could generate U.S source income” would be subject to the tax.
The Act covers a variety of organisations, including non-financial corporations: Any U.S.-source payment to a non-U.S. entity could be subject to the 30 percent withholding.
“The challenge (in the region) is because it’s a tax matter, it’s often being buried away within the tax group of an organisation, and the impact of it is not being brought to the CEO’s attention,” says Mark Jansen, partner with the Financial Services Industry Practice of PriceWaterhouseCoopers Singapore.
Initially, there was an opinion among many financial institutions that much of the cost of complying with FATCA could be avoided by merely avoiding U.S. clients. However, “as they understand more about FATCA and as the regulations are firming up, they understand that’s not a suitable approach”, says Gary Robert Haran Doyle, financial services director at KPMG Singapore.
The Act requires financial institutions to search existing “know your client” (KYC) data for seven specified indicia, which if found, may indicate the client as a U.S. person. Indicia include things like a U.S. residential address or a U.S. telephone number. If any of these indicia turn up, the financial institution is required to conduct additional due diligence on those clients to determine whether they are indeed U.S. persons. In addition, they must incorporate procedures for identifying U.S. persons into the process for opening new accounts.
“You can do the search and come up with no indicia. But you still have to do that search regardless of whether you have U.S. clients because you have to be able to prove under the agreement you have with the IRS that you’ve done these searches, and turned up no U.S. persons,” says Kinsley. “There’s an additional cost if you have Americans, but we don’t believe it’s substantial.”
Tight timelines
One of the key issues with FATCA in the region is the timing of its implementation. Some financial institutions have indicated that to do the additional data searches, they will need to either change or upgrade systems – something that can take 18 to 24 months, says Kinsley. However, financial institutions must enter into FFI agreements with the IRS by June 30, 2013, or face the 30 percent withholding beginning in 2014.
“With this kicking in next year, we don’t have 18 months left to implement those changes. (And) a lot of the financial institutions in Asia have been slow to take off,” says Kinsley.
Part of the reason such institutions have been slow to act is because FATCA’s final regulations have not been released. Organisations may also be hoping for government-to-government solutions that would ease the compliance burden.
“We’ve got to the point where it’s prudent for institutions to start working, and not just take a wait-and-see attitude,” says Karl Paulson Egbert, a Hong Kong-based national partner at Dechert LLP. “It’s also abundantly clear that many institutions are still trying to wait-and-see. That problem is particularly acute outside of Hong Kong.”
Some of the larger financial institutions have implemented dedicated FATCA teams. They have put together operational flow charts that go through how each of their business units will be impacted by FATCA, says Egbert. “They’ve come up with a plan to respond to it. They’ll slot in the details of how to comply as they’re available, but they have the structures in place.”
In contrast, he says, some private banks in other jurisdictions have indicated that they would not even try to comply with FATCA because not all of the information regarding compliance is available.
“They’re holding out for extensions in FATCA deadlines,” says Egbert, which even if they do occur, may not provide sufficient time to make the system changes necessary for compliance. “People that are waiting now, are walking into a bit of a trap.”
“The timeline is incredibly tight,” adds Jensen. “Organisations typically underestimate the effort around this. A lot of people see this as a tax or compliance issue only; they don’t realise this is much broader than that.”
Broad scope of applicability
FATCA was drafted very broadly in an effort to capture as many types of financial institutions as possible. The consequence is that any financial institution that holds U.S. securities would be required to comply. The act also captures non-financial corporations.
For example, says Kinsley, a bank may hold U.S. treasuries as part of its liquidity management, in which case, the bank would have to comply. If it does not, then it would suffer 30 percent withholding on the interest flows and gross sale proceeds on those instruments.
“If you have no U.S. investments, potentially there’s nothing that could suffer the 30 percent withholding. But with the current economic conditions, the U.S. dollar is still the world’s safe haven,” says Kinsley. “If you’re going to suffer withholding, you can’t suffer 30 percent withholding on U.S. treasuries.”
Similarly, if a financial institution makes U.S. securities available to its clients, it would have to make sure the client is not a U.S. person before paying out any proceeds associated with those securities. It would also have to withhold 30 percent if it failed to verify that the client is not a U.S. person, or do the additional due diligence and disclosure to the IRS if the client is a U.S. person, he adds.
FFIs are also broadly defined under FATCA and would include fund houses, securities houses, pension funds, and private trusts. Even provident funds, such as Singapore’s Central Provident Fund, are potentially within scope.
Unless they satisfy the requirements for specific narrow exemptions provided by the February 2012 FATCA (draft) regulations, mandatory provident funds (MPFs) do fall within the scope of FATCA,” says Weisman. “Unfortunately, the exemptions were drafted very narrowly. So MPFs in Hong Kong, Singapore, and Malaysia generally would fall within the scope of FATCA under the draft regulations.”
“If you take a Hong Kong MPF – with some of those funds you can invest directly in the U.S. – those funds would overnight be worth 30 percent less if that MPF does not comply with FATCA, or if it is not ultimately exempt,” says Kinsley.
Financial institutions may also face significant implementation challenges with regard to corporate clients. FATCA requires that financial institutions report substantial U.S. owners of corporate clients – that is any U.S. person who owns more than 10 percent of the corporation, either directly or indirectly.
“If you’ve got 100,000 corporate clients and they may be owned by other corporations that are owned by other corporations, the level of drilling down that has to go on is going to be one of the major cost pieces for the industry,” says Haran Doyle of KPMG Singapore.
Corporations other than financial institutions
In addition, FATCA also has significant implications for companies other than financial institutions.
“What’s slipped under the radar a bit is the idea of non-financial foreign entities (NFFEs), which are technically subject to FATCA,” says Jeremy Naylor, a partner with White & Case in New York, who focuses on FATCA issues.
Any non-financial entity that has U.S. source income will be subject to the 30 percent withholding tax, unless it certifies that it does not have substantial U.S. ownership, or falls within one of the enumerated exceptions. Alternatively, if such a non-financial entity does have substantial U.S. ownership, it must provide the IRS with the identifying information of those owners required by FATCA, says Naylor.
Furthermore, the definition of financial institution in the Act is so broad that it covers entities that would not traditionally be considered financial institutions. “They might find themselves inadvertently considered financial institutions anyway,” says Egbert.
“Corporations other than financial institutions need to understand their obligations under FATCA,” adds Weisman of Baker & McKenzie. These include potential obligations to impose withholding tax in certain circumstances, and to provide certain FATCA-related information to payors when requested.
There are a number of carve-outs for NFFEs – the most prominent of which is an exemption for publicly traded companies – but if those do not apply, the company must comply with FATCA or face the withholding tax.
“Corporate counsel should be keeping this in mind,” says Naylor, “because when FATCA’s withholding taxes apply, they’ll need to be able to certify that they are FATCA compliant. They need to take a look at their organisations, and make sure they’re able to make these certifications.”
Conflict of laws
Another issue with FATCA is that it may conflict with local laws in some jurisdictions – particularly data privacy laws – making compliance a challenge, and local governments may not be addressing this challenge.
“There is a lack of government assistance with regard to FATCA across Asia. Largely, governments are saying to the financial institutions that you need to comply with FATCA, but make sure you comply with local law. But the two may be in conflict,” says Kinsley.
For example, he says, no Chinese banks could comply with FATCA at present because Chinese law prevents them from reporting the information they would be required to report to the IRS under the Act -- and four of the top 15 banks in the world are Chinese. “We are not aware of the Chinese and American governments having addressed this issue to date,” says Kinsley.
“In Asia, a lot of governments have not really woken up to FATCA. That’s why there may be little or no involvement from (these) government(s) in helping local financial institutions deal with FATCA,” he adds.
Government-to-government solutions
What many are hoping for is a government-to-government solution to FATCA compliance challenges. To date, two models for such solutions have emerged.
In February, five European countries – the UK, Germany, France, Italy and Spain – announced their intention to work with the U.S. to come up with a government-to-government solution to FATCA. Under this model, local governments would implement laws requiring their financial institutions to report FATCA-type information to local tax authorities. Financial institutions in these countries would not have to enter into agreements directly with the IRS, because they would be required to comply with rules similar to FATCA imposed by local governments. Local tax authorities would then pass that information on to the IRS. In turn, the IRS would provide reciprocal information to those local tax authorities.
For example, under this proposed model, the tax authorities in the UK will collect information about U.S. citizens and their investments in the UK and share that information with the IRS. In turn, they would receive information from the IRS about UK citizens and their investments in the U.S.
The main challenge with this model is that it requires local governments to pass new laws. “If you go to a legislature and say we want to pass something similar to FATCA so we can basically be agents of the U.S. government, you may find that it meets with a lot of resistance unless there is a benefit to the country concerned,” says Kinsley. “It’s one thing to say we’ll pass these laws; it’s another thing to actually get them passed.”
More recently, Japan and Switzerland announced they are working with the U.S. to develop an intergovernmental agreement to facilitate FATCA compliance. Under this model, financial institutions would enter into agreements directly with the IRS. However, where local privacy laws prevent financial institutions from sharing information about recalcitrant accountholders directly with the IRS, the IRS could request such information directly from the Japanese or Swiss tax authorities. These authorities would then obtain such information from their local financial institutions, and share it with the IRS.
The benefit of the second model is that the local country’s government may not have to pass any new local laws. “They will agree to pass the sensitive information on, but they don’t have to go and pass local laws similar to FATCA, which is a very time-consuming issue,” says Kinsley.
However, while the proposed government-to-government arrangements address data privacy issues, they do not deal with the cost burden of compliance.
They “change nothing fundamentally, except who you actually report to,” says Jensen. “The wish is that such agreements actually reduce the cost burden.”
Furthermore, government-to-government models are in the planning stages and will take time to fully develop and implement. With less than a year before financial institutions comply with the act, time is not a luxury most can afford.
Follow us on Twitter: @ALB_Magazine.
