Tax Dodgers Beware: New Foreign Account Tax Compliance Legislation
Over the past year, the bank secrecy world has changed dramatically. Major international financial institutions have been under the gun of the U.S. Department of Justice to provide account information for their U.S. account holders. The Internal Revenue Service has also joined the effort and on March 23, 2009, established a temporary penalty framework to apply to voluntary disclosures by U.S. persons of their non-U.S. bank accounts to encourage them to become tax compliant. This special program ended on October 15, 2009, but individuals continue to enter the IRS’ voluntary disclosure program and disclose their non-U.S. bank accounts even though the penalty framework is uncertain. The IRS announced that the special voluntary disclosure program was very successful and that nearly 15,000 taxpayers came forth during the program.1
The current environment (the U.S. Department of Justice’s aggressive pursuit of taxpayers’ financial information at non-U.S. banks and the United States’ need for increased tax revenue) has created the perfect storm to pass legislation to address U.S. persons’ use of non-U.S. bank accounts. On October 27, 2009, Senate Finance Committee Chair Max Baucus (D-Mont), House Ways and Means Committee Chair Charles Rangel (D-NY), senior Senate Finance Committee member John Kerry (D-MA), and Ways and Means Select Revenue Subcommittee Chair Richard Neal (D-MA) introduced legislation “to clamp down on tax evasion and improve taxpayer compliance.” The legislation was known as the Foreign Account Tax Compliance Act (FATCA).2 FATCA follows previous efforts to combat foreign accounts, including President Obama’s release of the General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals (usually known as the Greenbook) on May 12, 2009, Senator Max Baucus’ proposals of March 12, 2009, and Senator Carl Levin’s Stop Tax Haven Abuse Act introduced on March 2, 2009.
On March 18, 2010, President Obama signed into law H.R. 2847, the Hiring Incentives to Restore Employment Act (the act or the HIRE Act). The act provides incentives for job creation, but in order to pay for the incentives, the act also contains significant changes that will affect foreign financial institutions that choose to do business with U.S. persons. Of the 12 pages in the U.S. Congressional Record that contain the act, six pages are dedicated to foreign account tax compliance.3 Thus, although the act is commonly referred to as the HIRE Act for its focus on job creation, one of its main purposes is to target tax dodgers’ use of foreign accounts. The act incorporates substantially all of FATCA, with one important exception: FATCA would have imposed reporting requirements on material advisors, including attorneys, accountants, and other professionals, who advise on acquisitions or formations of foreign entities.4 Although this provision did not make it into the act, practitioners should take note that the U.S. Congress and the U.S. Treasury tried to bring attorneys, accountants, and other professionals into their information gathering police force.
The focus of the foreign account compliance provisions of the act is to increase transparency in the international banking world. As indicated by Senator Levin, “[T]ax dodgers conceal billions of dollars in assets within secrecy-shrouded foreign banks, dodging taxes and penalizing those of us who pay the taxes we owe. The Permanent Subcommittee on Investigations, which I chair, has estimated that these tax-dodging schemes cost the federal treasury $100 billion a year.”5 Under the act, the number of pages of the Internal Revenue Code of 1986, as amended, increases with new requirements for foreign banks to disclose their U.S. account holders, thereby making it more difficult for tax dodgers to hide their assets. However, the U.S. Congress is not done in this area. As Senator Levin said, “[T]his legislation is not a silver bullet. In fact, I believe our tax enforcement regime could be strengthened by [further legislation].”6
New Withholding for U.S. Source Interest, Dividends, and Other Payments
• New 30 Percent Withholding Tax — The act creates a new Code §1471, which imposes a withholding tax of 30 percent of the amount of any “withholdable payment” to a foreign financial institution.7 In order to avoid this 30 percent withholding tax, a foreign financial institution can either 1) enter into a reporting agreement with the IRS, or 2) be deemed to meet the reporting requirements. The new withholding tax comes into effect on January 1, 2013.
• Withholdable Payment — A withholdable payment is 1) any payment, 2) of investment type income, including interest and dividends, 3) from U.S. sources. This new withholding tax is similar to the current 30 percent withholding tax imposed on payments of similar types of income to non-U.S. persons, commonly referred to as FDAP income.8 However, in addition to withholding on FDAP income, the act imposes a 30 percent withholding tax on any gross proceeds from the sale of any property of a type which can produce interest or dividends from U.S. sources. Thus, if shares of stock are sold, a 30 percent withholding tax will apply on the gross proceeds from such sale.
• Foreign Financial Institution — A foreign financial institution is any financial institution which is a foreign entity. A financial institution is any entity that 1) accepts deposits in the ordinary course of a banking or similar business, 2) as a substantial portion of its business, holds financial assets for the account of others, or 3) is engaged primarily in the business of investing, reinvesting, or trading in securities, partnership interests, commodities, or any interest in such securities, partnership interests, or commodities. Therefore, institutions such as banks, investment firms, private equity funds and hedge funds will likely be treated as foreign financial institutions for purposes of new Code §1471. Some practitioners have questioned whether a private trust company will be treated as a foreign financial entity because a private trust company is essentially a company formed for the specific purpose of acting as a trustee, which is a type of relationship rather than an entity.
• Agreement — In order to avoid the new 30 percent withholding tax, a foreign financial institution can enter into an agreement with the IRS, under which the foreign financial institution agrees to 1) obtain information about account holders at its institution to determine which (if any) are U.S. accounts; 2) comply with verification and due diligence procedures that the IRS may require;9 3) in the case of any U.S. account, to report on an annual basis certain information as described below; 4) deduct and withhold 30 percent tax on any passthru payment10 to a recalcitrant account holder11 or another foreign financial institution which does not meet the requirements of new Code §1471; 5) comply with requests by the IRS for additional information; and 6) in any case in which any foreign law would prevent the reporting of any information, the financial institution would a) attempt to obtain a valid and effective waiver of such law from account holders, and b) if such a waiver is not obtained, to close such account.
Any agreement entered into between the IRS and a foreign financial institution may be terminated by the IRS if the IRS determines that the foreign financial institution is out of compliance with the agreement.
If a foreign financial institution is treated as a qualified intermediary by the IRS, the requirements of the act are in addition to any reporting or other requirements imposed by the IRS.12
• Annual Reporting — The agreement described above requires the foreign financial institution to report the following with respect to each U.S. account maintained by such institution: 1) The name, address, and TIN of each account holder; 2) account number; 3) account balance; and 4) gross receipts and gross withdrawals from the account.
A foreign financial institution can avoid reporting the account balance and gross receipts and gross withdrawals if such institution makes an election, which requires such institution to report information as if it were a U.S. financial institution.
•Deemed Compliance — A foreign financial institution may be treated by the IRS as meeting the requirements of the act if the institution 1) complies with any procedures that the IRS may prescribe to ensure that the institution does not maintain U.S. accounts and meets any other requirements that the IRS may prescribe with respect to accounts of other foreign financial institutions maintained by such institution, or 2) is a member of a class of institutions with respect to which the IRS has determined that the application of the act is not necessary to carry out the purposes of the act. For example, the IRS may identify that certain controlled foreign corporations owned by U.S. financial institutions as a class of institutions are deemed to have satisfied the requirements of the act.13
•Withholding Tax Applicable to Nonfinancial Foreign Entities — The act also creates a new Code §1472, that imposes a withholding tax of 30 percent of the amount of any withholdable payment to a nonfinancial foreign entity. A nonfinancial foreign entity is any foreign entity which is not a financial institution as described above. In order to avoid this withholding, the beneficial owner or the payee must provide the withholding agent either 1) a certification that such beneficial owner does not have any substantial U.S. owners, or 2) the name, address, and TIN of each substantial U.S. owner of such beneficial owner. In addition, the nonfinancial foreign entity cannot know that the information provided is incorrect and must report the information gathered from each substantial U.S. owner to the IRS.
New Reporting Requirements for Foreign Assets
• Reporting Foreign Assets — The act creates a new Code §6038D, which imposes new reporting requirements for individuals. Any individual who holds an interest in a “specified foreign financial asset” must attach to his or her tax return certain information if the aggregate value of all such assets exceeds $50,000. A specified foreign financial asset is 1) any financial account maintained by a foreign financial institution, and 2) any of the following assets that are not held in an account maintained by a financial institution: 1) any stock or security issued by a non-U.S. person; 2) any financial instruction or contract held for investment that has an issuer or counterparty which is not a U.S. person; and 3) any interest in a foreign entity.
• Reporting Requirement — The individual must report the maximum value of the assets in addition to the following:
1) Accounts: In the case of any account, the name and address of the financial institution and the number of the account.
2) Stock or security: In the case of any stock or security, the name and address of the issuer and such information as is necessary to identify the class or issue of which such stock or security is a part.
3) Other: In the case of any other instrument, contract, or interest, such information as is necessary to identify such instrument, contract, or interest, and the names and addresses of all issuers and counterparties with respect to such instrument, contract, or interest.
These new reporting requirements apply to any domestic entity that is formed or used for purposes of holding, directly or indirectly, specified foreign financial assets, in the same manner as if such entity were an individual. Subject to a reasonable cause exception, if an individual fails to furnish the information described above, the IRS will impose a penalty of $10,000, which increases if the failure continues after notification from the IRS. In addition, the act increased the normal 20 percent underpayment penalty to 40 percent for any portion of an underpayment that is attributable to any undisclosed foreign financial asset. Moreover, the act increased the statute of limitations to six years in connection with significant omissions of income in connection with foreign financial assets.
As stated by the Joint Committee on Taxation, although the information required to be reported above is similar to the information reported on Form TD F 90-22.1 (FBAR), it is not identical. For example, a beneficiary of a foreign trust who is not within the scope of the FBAR reporting requirements because his or her interest in the trust is less than 50 percent may nonetheless be required to disclose the interest in the trust with his or her tax return if the value of his or her interest in the trust together with the value of other specified foreign financial assets exceeds $50,000.14 The new reporting requirements are supplemental to the FBAR — they do not replace the FBAR.
The act also imposes new reporting requirements for passive foreign investment companies (PFICs), electronic reporting requirements on certain financial institutions, a number of changes to the rules governing foreign trusts, and addressing “dividend equivalent” payments that are structured to avoid the 30 percent withholding tax on dividends payable to nontreaty recipients. These additional changes by the act are important, but are beyond the scope of this article.
The act will increase transparency in the international financial world, but at increased compliance costs by foreign financial institutions. In order to comply with the act, foreign financial institutions will likely need to spend significant sums of money to create operating systems to comply with the act. When introducing FATCA, Senator Rangel said, “[T]his bill offers foreign banks a simple choice — if you wish to access our capital markets, you have to report on U.S. account holders. I am confident that most banks will do the right thing and help to make bank secrecy practices a thing of the past.”15
Some foreign financial institutions may determine that the cost of compliance will outweigh the benefits of managing U.S. account holders. In fact, some of the clients that the author has represented in the IRS voluntary disclosure program have been told by certain foreign banks that the banks no longer want to manage U.S. accounts and have forced the clients out of their institution, notwithstanding the clients’ significant account balances.
In addition, in order to avoid complications, some foreign financial institutions will likely avoid investing in U.S. stocks and bonds altogether. Thus, an unintended result of the act may be to drive capital away from the United States to more user-friendly jurisdictions. Lastly, other jurisdictions may pass similar legislation and require U.S. financial institutions to comply with similar requirements for their foreign account owners. Thus, U.S. financial institutions may want to prepare for reciprocal treatment from other jurisdictions, as illustrated by Raymond Baker, director of Global Financial Integrity, who stated, “While this bill only covers information regarding U.S. taxpayers, it sets a precedent for other countries to join the fight by imposing similar measures to combat the kind of banking secrecy that allows illicit funds to be hidden from law enforcement around the world.”16
In summary, the act creates significant legislation that will affect almost every foreign financial institution. The act is also a significant step toward a more transparent international financial world.
1 See Tax Analyst 2009 TNT 233-3, Victor Song to Replace Retiring CI Chief Mayer, December 8, 2009.
2 United States Congress News Release, dated October 27, 2009.
3 Congressional Record — Senate, February 11, 2010 (Tax Analyst Doc. 2010-3117).
4 The ABA Section of Taxation commented on this provision of FATCA recommending deletion from the legislation for a number of reasons, including issues related to the attorney-client privilege. See letter by Stuart M. Lewis, chair, Section of Taxation, to Max Baucus and Ranking Members of Congress, dated December 3, 2009.
5 Statement by Senator Carl Levin, D-Mich, made on March 17, 2010, with respect to the act.
7 The new Code provisions are found in Title V of the Hire Act.
8 Payments of U.S.-source fixed or determinable annual or periodical income (FDAP income), including interest, dividends, and similar types of investment income, that are made to foreign persons are subject to U.S. withholding tax at a 30 percent rate, unless the withholding agent can establish that the beneficial owner of the amount is eligible for an exemption from withholding or a reduced rate of withholding under an income tax treaty. I.R.C. §§871, 881, 1441 and 1442.
9 The U.S. know-your-customer rules require financial institutions to develop and maintain a written customer identification program and anti-money laundering policies and procedures. The U.S. know-your-customer rules are primarily found in the Bank Secrecy Act of 1970 and in Title III, the International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001 of the USA Patriot Act.
10 A passthru payment means any withholdable payment or other payment to the extent attributable to a withholdable payment.
11 A recalcitrant account holder means any account holder who 1) fails to comply with reasonable requests for the information to determine if the account is a U.S. account, or 2) fails to provide a waiver in the event a foreign law prevents reporting any information.
12 A qualified intermediary is defined as a foreign financial institution that has entered into a withholding and reporting agreement with the IRS.
13 Joint Committee on Taxation, Technical Explanation of the Revenue Provisions Contained in Senate Amendment 3310, the “Hiring Incentives to Restore Employment Act,” under consideration by the Senate (JCX-4-10), February 23, 2010, page 41.
14 Id. at 60.
15 United States Congress News Release, dated October 27, 2009.
16 Statement by the Global Financial Integrity in response to the act, dated March 19, 2010.
Abrahm W. Smith is an associate in Baker & McKenzie’s tax department in its Miami office. Over the past year he has had extensive experience with the IRS’ voluntary disclosure program, representing numerous individuals with undisclosed, offshore bank accounts.
This column is submitted on behalf of the Tax Section, Guy E. Whitesman, chair, and Michael D. Miller and Benjamin Jablow, editors.