FATCA Regulations and Their Impact on Financial Institutions

Introduction to FATCA

FATCA — the Foreign Account Tax Compliance Act — was enacted as part of the Hiring Incentives to Restore Employment (HIRE) Act of 2010. It requires financial institutions to utilize enhanced due diligence procedures to identify U.S. individuals who have invested in non-U.S. financial accounts or non-U.S. entities. The intention of FATCA is to bar U.S. persons from hiding income and assets overseas.

A foreign financial institution (FFI) faces significant consequences should it fail to enter into an agreement with the Internal Revenue Service (IRS). This agreement is the first step in aligning all key stakeholders — including operations, technology, risk, legal, and tax — which is essential for successful FATCA compliance.¹

Any FFI that fails to comply is subject to a withholding tax of 30% on any withholdable payment made to its proprietary account. Additionally, accountholders who fail to produce required FATCA documentation "would be deemed recalcitrant," and the FFI would be bound to deduct a 30% withholding tax on any withholdable payment credited to their accounts.² Achieving compliance therefore requires significant process and technology changes on the part of multinational financial institutions.

Financial institutions are advised to take the following specific steps toward compliance: (1) perform a current-state assessment of their systems and operations; (2) conduct gap analyses against their identified requirements; (3) develop actions to implement changes required for FATCA compliance; and (4) evaluate their legal entities to determine whether they are FFIs or otherwise covered by FATCA.³

Responsible Officer Duties and Certification Requirements

The Responsible Officer (RO) of each Participating Foreign Financial Institution (PFFI) is required to make certifications to the IRS concerning the PFFI's compliance. The following certifications are required under FATCA:

(1) Preexisting High Value Accounts. With respect to preexisting individual accounts, the RO must certify to the IRS within one year of the effective date of the FFI Agreement that the PFFI has completed the review of all High Value Accounts.

(2) Remaining Preexisting Accounts. With respect to all remaining preexisting accounts, the RO must certify to the IRS within two years of the effective date of the FFI Agreement that the PFFI has completed the review of those accounts.

(3) Policies and Procedures. The RO must certify to the IRS within one year of the effective date of the FFI Agreement that, to the best of the RO's knowledge — after conducting a reasonable inquiry — the PFFI did not have any formal or informal practices or procedures in place from August 6, 2011, through the date of certification that were designed to assist accountholders in avoiding FATCA.

(4) Compliance Certification. The FFI Agreement requires the participating FFI to adopt written policies and procedures governing its due diligence procedures for identifying and documenting accountholders, as well as its withholding and reporting obligations. The FFI Agreement further requires the participating FFI to conduct periodic reviews of its compliance with these policies and its FATCA obligations. Based on the results of such reviews, an RO of the PFFI will periodically certify to the IRS the PFFI's compliance with its obligations under the FFI Agreement, and may be required to provide factual information and disclose material failures.⁴

The FATCA certifications are due on January 15, 2015 — one year from January 1, 2015, the earliest possible date an FFI Agreement could be in effect. FFIs with agreements already effective as of January 1, 2014, are required to have procedures in place to assist in the identification of U.S. accounts prior to that start date.

FATCA Provisions and Compliance Challenges

The two-year mandate of the Implementation Guidance Committee (ICG) encompassed two aspects: (1) legal and policy issues, primarily relating to the extent to which collective investment vehicles or their investors are entitled to treaty benefits; and (2) procedural aspects regarding claims for reductions in source-country withholding tax provided for by treaty when assets are held indirectly — whether through collective investment vehicles (CIVs) or through nominees and custodians.⁶

Mukadi (2012) reports that the enactment of FATCA "is a proof that tax information exchange mechanisms and assistance in tax collection through ordinary tax treaties or tax information exchange mechanisms have proven to be inefficient."⁷ Mukadi further notes that regardless of the tax system in place — worldwide taxation or territorial income taxation — international taxation is enforced through two principal legal mechanisms: (1) domestic international tax law, which is national or domestic to every country; and (2) tax treaty law, which is international and may be bilateral or multilateral.⁷

According to a report published by Oracle, FATCA "stands to transform the global tax framework and the way that financial institutions track and report on their clients' financial assets."⁸ With the law set to begin taking effect in 2014, financial institutions around the globe were compelled to assess their compliance architecture — including Know Your Customer (KYC) and Anti-Money Laundering (AML) procedures and systems — in order to define new structures, roles, processes, and IT solutions required for cost-effective and complete compliance.

FATCA follows the negative presumption rule, meaning that all accountholders are considered to be U.S. persons unless proven otherwise. While determining individual accountholders is relatively straightforward for most institutions, the law also applies to beneficiaries and family members, introducing significant additional complexity. Moreover, the law applies to both traditional and nontraditional financial institutions such as group companies and brokers.⁹ Nontraditional entities have not always been required to gather information extensively through KYC and AML processes, and many of these institutions are therefore beginning their compliance initiatives at near ground level.¹⁰

FATCA requires a full history — known as a "certification" — for each client that identifies indicia of possible U.S. status.¹¹ Under the law, there are six proposed indicia of U.S. status:

(1) U.S. citizenship or lawful permanent resident status; (2) U.S. birthplace; (3) a U.S. residence address or correspondence address; (4) standing instructions to transfer funds to a U.S.-maintained account, or directions regularly received from a U.S. address; (5) an "in care of" or "hold mail" address that is the sole address on file for the client; or (6) a power of attorney or signatory authority granted to a person with a U.S. address.¹²

The possession of a single indicium is not in itself an assumption that an account is owned by a U.S. person, but it does require that the account be examined more closely. For each customer with an indicium of U.S. citizenship, FFIs are required to collect significant additional documentation.¹³ Organizations must first assess the information currently on file and determine what further information needs to be gathered and updated for each file. Upon determining that the accountholder is a U.S. person, FFIs are required to collect and report the following:

(1) The name, address, account number(s), and taxpayer identification number of each U.S. person accountholder; (2) that person's account balance or value at year end; and (3) gross dividends, interest, or other income paid or credited to the account(s).¹⁴

Organizations must also "aggregate the number and value of accounts held by recalcitrant accountholders at the end of the calendar year, grouped as those that have U.S. indicia, those that do not, and those that are dormant."¹⁵ Financial institutions face multiple challenges in meeting these requirements, since "customer information can be spread across disparate systems and information silos, leaving FFIs struggling to accurately assess which information they have for customers across the enterprise. This, in turn, can lead to time-intensive and costly duplicate efforts and multiple information requests to a single customer, as FFIs take an account-centric opposed to a customer-centric approach to U.S. person identification."¹⁶