The Foreign Account Tax Compliance Act (“FATCA”) has been all over the news since it went into effect July 1 of this year. As is usually the case, some news articles do a nice job of reporting actual facts and quality opinions, while others muddy the waters in service of presenting sensational claims.
This article series cuts through the fear and hype to explain exactly how FATCA applies to different types of offshore investment structures. This first article discusses FATCA basics and terminology. The following articles then apply these rules to various offshore structures, from a direct offshore investment (i.e., the no-structure structure), to an investment through a non-U.S. corporation, to an investment through a non-U.S. trust.
I have done my best to simplify and condense the complicated FATCA rules (which live in at least a thousand pages of regulations and other guidance), but simplification can only go so far. So, please fasten your seatbelts—there’s some unavoidable technical jargon ahead.
Beware: Here There be Dragons
An additional word of warning: FATCA is still in its infancy. Various players in the offshore industry are still determining how they believe FATCA works and how they believe others believe FATCA works.
So, any particular non-U.S. bank or other offshore service provider may have its own ideas about how to apply FATCA’s finer details in particular situations. Thankfully, the IRS has announced that the first two years of FATCA will be a “transition period,” which will give all the players time to iron out these differences and streamline their FATCA compliance processes.
FATCA Terminology and Taxonomy
With all of the preliminaries out of the way, let’s dive in.
FATCA divides all non-U.S. entities into two categories: “foreign financial institutions” (“FFIs”) and “non-financial foreign entities” (“NFFEs”). The term “FFI” includes entities that are obviously financial institutions, like non-U.S. banks and brokerages, but it also includes some that may not seem to fit the definition at first, like insurance companies that offer life insurance policies with an investment element.
Additionally, the term “FFI” also encompasses a much broader category, called an “investment entity,” which is any non-U.S. entity described in any of the following three categories:
- The entity makes more than 50% of its income from engaging in certain activities (e.g., trading, investing, administering, or managing assets) on behalf of customers;
- The entity (i) derives more than 50% of its income from investing in securities and (ii) is managed by another entity as part of the manager’s business (such as a trustee); or
- The entity is a collective investment vehicle, mutual fund, private equity fund, etc.
An NFFE is any non-U.S. entity that is not an FFI. (Sometimes things are nice and simple, even in FATCAland). NFFEs are further divided into two categories in accordance with how they derive their income. “Passive NFFEs” are those that receive more than 50% of their income from securities, and “Active NFFEs” are all others.
The whole idea of FATCA is to use the threat of a withholding tax to get non-U.S. entities to provide information about their U.S. owners and accountholders. With FATCA, the IRS is telling foreign entities that they must name names or pay up. So, an FFI or NFFE that does not take the necessary action to avoid withholding (as described below) will suffer a 30% withholding tax on certain types of U.S.-source income. This withholding tax is not refundable in certain cases.
Currently, only U.S.-source interest and dividends (and similar types of passive income) are subject to the withholding tax. However, starting January 1, 2017, the withholding tax will also apply to the gross proceeds from the sale of securities—not the gain, but the full gross proceeds. So, if an FFI buys a U.S. security for $100 and then sells it for $100, it will only receive $70 unless it takes action to avoid FATCA withholding.
This withholding tax is FATCA’s only negative impact. If an entity does not take the necessary steps to avoid FATCA withholding, but no event ever occurs that would require withholding in the first place, then FATCA essentially has no impact on the entity. However, note that some offshore service providers may choose to avoid offering services to (or otherwise working with) certain types of entities that choose to remain FATCA non-compliant.
Avoiding FATCA Withholding
The main difference between FFIs and NFFEs is the steps they must take to avoid FATCA withholding.
An Active NFFE can avoid FATCA withholding simply by certifying that it is an Active NFFE. A Passive NFFE can avoid FATCA withholding by either (a) providing information about its U.S. owners who own more than 10% (“substantial U.S. owners”) or (b) certifying that it has no substantial U.S. owners. An NFFE makes these certifications and provides this information on IRS Form W-8BEN-E, which it must provide to non-U.S. banks and U.S. withholding agents.
Avoiding withholding is more difficult for FFIs. An FFI can avoid FATCA withholding by registering with the IRS, conducting due diligence on its owners/accountholders, and reporting U.S. owners/accountholders to the IRS. An FFI that undertakes this course of action is called a “participating FFI.” Also, as discussed in a later article, certain FFIs that are “investment entities” can avoid FATCA withholding in ways that are less burdensome than becoming participating FFIs.
Part 2 Preview
Now that we’ve covered FATCA terminology and the basic operation of the FATCA rules, Part 2 will begin applying these rules to offshore investment structures.