In Search of HIRE Ground: FATCA Provisions of the HIRE Act Create Extensive Compliance Burden

The United States has enacted what may be the broadest piece of tax and information reporting legislation ever drafted. Ostensibly aimed at creating domestic jobs, the Hiring Incentives to Restore Employment Act of 2010 (the HIRE Act) has a sting in its tail. In order to offset the cost of new jobs, the HIRE Act incorporated a bill known as FATCA, the Foreign Account Tax Compliance Act. This piece of legislation will affect almost every investor who invests into the US or invests through any intermediary that has other clients who invest into the US.

FATCA was designed to reduce US tax fraud by obtaining account information of US citizens, green card holders and US tax residents investing through non-US entities. Conveniently for US tax authorities that are already spread thin, the burden of identifying and reporting such individuals has been placed on the so-called ‘foreign financial institutions’ (FFIs), an expansive term covering entities from banks to hedge funds, trusts to family offices.

It is not surprising that such broad legislation would leave its print on non-US banks, investment houses, brokerages, mutual funds and hedge funds. What is surprising is that the IRS appears ready to extend the reach of FATCA to cover life insurance providers, trusts, family offices and privately owned investment vehicles. Some non-US service providers are reacting by cutting ties with those clients and others are segregating them into specialised divisions.

However, FFIs cannot escape the reach of FATCA simply by avoiding US investors. Any FFI that wishes to invest in the US or via the US will need to comply. Those who do seek to exclude US individuals will be faced with the ongoing duty of monitoring whether any of their clients become resident in the US or obtain a so-called green card.

Implications for the private client industry will be immense. The relevant provisions of the legislation will take effect from 1 January 2013 and all affected organisations will need to have their compliance procedures implemented prior to that date.

Requirements for FFIs

Under the new rules, unless an FFI enters into an agreement with the IRS to report information about its US account holders each year, a 30 per cent withholding tax will be applied to all US investments. The withholding tax would apply to virtually all investments by the FFI into the US, whether made on its own behalf or on behalf of its ‘account holders’, regardless of whether or not they are US persons. Clients who themselves have no connection with the US will nevertheless be affected if they invest via any FFI entering into one of these agreements.

FFIs wishing to avoid this new 30 per cent withholding tax will therefore have to review their client base annually to identify to the IRS any US persons amongst its clients and report the names and addresses of each US account holder, as well as the account number, the account balance and any gross payments or withdrawals through the account. The FFI will also be required to comply with any due diligence or verification procedures imposed by the US Department of Treasury and comply with any requests for additional information from the Treasury.

Which institutions and entities are caught by FATCA?

FATCA effectively creates a blacklist of non-US institutions comprised of those that sign up to the new client identification and disclosure requirements and those that do not. For those institutions signing up to FATCA, they will effectively be undertaking the burden of identifying US citizens, residents and green card holders and reporting those individuals to the IRS.

The primary targets are extremely broadly defined as ‘foreign financial institutions’, which includes not only banks and financial institutions themselves but also hedge funds, private equity funds, mutual funds – in fact virtually any non-US collective investment structure of any kind, unless the IRS issues regulations to narrow the definition. Also squarely included within the definition of FFIs are custodians.   This necessarily includes entities such as trusts and family offices, who would not themselves fall under the definition of financial institutions, but who will nevertheless be required to determine whether US persons are deemed to be ‘account holders’ for the purposes of the legislation.

The IRS took a crack at putting flesh on the bones of FATCA by releasing Notice 2010-60 at the end August. The Notice has provided some guidance on the mechanics of how financial institutions will need to identify their clients and that is discussed below. However, the IRS left open the question as to how FATCA will specifically apply to trusts, family offices, trustees and funds.

Remarkably, the Notice implies that individual trusts themselves will be classified as FFIs, although some ‘small’ family trusts may be exempted. This will mean that each individual trust for which a trust company serves as trustee will have to enter into a special agreement with the IRS.

Uncovering ‘US accounts’

As part of the agreement with the IRS, FFIs will generally be required to disclose information relating to ‘United States accounts’ (defined broadly) held by: (i) a ‘specified United States person’ (this term includes most US persons other than publicly traded corporations, certain tax-favoured entities and US governmental entities); or (ii) a ‘US-owned foreign entity’.

As detailed by the Notice, such disclosure will require extensive due diligence. For pre-existing accounts held by individuals, FFIs will need to search their electronic databases for ‘indicia of US status’ (including citizenship, address, place of birth, instructions to transfer to US accounts, etc).

For new accounts opened by individuals, FFIs must obtain ‘documentary evidence’ establishing the status of the individual. For individuals claiming non-US status, the FFI must then cross-check this against ‘all other information collected in connection with’ the new account holder. Where there are indicia that an individual claiming non-US status has a US connection, further documentation must be obtained to establish non-US status.

Identifying US individuals

Assuming that FFIs wish to continue to invest into the US either for any of their clients or on their own behalf without suffering withholding, they will need to understand the composition of not only their direct customers but also the beneficial ownership of those accounts held via trusts, companies and other entities. Related compliance and reporting costs will therefore increase dramatically prompting suggestions that many would opt to refuse services to US clients, rather than handle the added compliance burden.

Identifying those US clients will, however, likely prove challenging. With respect to individual account holders, anyone who is US tax resident will have to be identified. With respect to any individual living outside of the US, every individual account holder who is either a US citizen and or green card holder also will have to be identified. While most US citizens living outside of the US do hold US passports, thereby easing identification to some degree, anyone born in the US is by definition a US citizen regardless of whether or not they hold a US passport.   Further, many US citizens hold dual citizenship such that it is unlikely that institutions will be allowed to rely on the fact that they may have another country’s passport on record for an account holder. In other words, it is likely that all account holders will need to be asked if they might have dual citizenship!

With respect to accounts held by trusts and other entities, the compliance requirements will become even more challenging. All such trusts and entities with accounts at FFIs complying with the HIRE Act will need to determine the deemed individual ‘beneficial owners’ of such accounts under look through rules expected to be issued in the coming months. Thus in the case of trusts, every trustee will need to understand how each of their trusts are classified for US tax purposes and will then need to look to either the identity of the settler or the trust beneficiaries in determining which of them, if any, may be US clients for these purposes and then reporting those individuals to the FFI obligated to turn that information over to the IRS.

Conclusion

Many institutions are beginning to accept that FATCA cannot be ignored. In addition to assembling teams to implement the new compliance requirements, some institutions have already begun to implement ‘best practices’ before taking on additional US clients to avoid undertaking a ‘needle in a haystack’ search for lurking US individuals at a later date. Further, some US investors are looking to eliminate ongoing US tax and reporting obligations by terminating US residence, handing in a US green card or even expatriating from the US. Handing in green cards or passports are significant steps, raising their own tax and reporting considerations, and underscore the far reaching implications of the FATCA legislation.

As long as US investments are seen as an important piece of a global investment portfolio, non-US investors and institutions will need to play by the US rules. Non-US banks and financial institutions will need to accept the high costs of compliance with the HIRE Act or consider limiting involvement with US customers and US markets. Eliminating their US client base may, however, prove more challenging and less practical than first anticipated given the reach of the rules not only to all US residents but also all US citizens and green card holders wherever they live and regardless of what other passports they may hold and whatever trusts and entities through which they might invest.