I often receive questions from offshore service providers asking whether they need to register with the Internal Revenue Service due to the Foreign Account Tax Compliance Act (“FATCA”). This concern is understandable—FATCA issues are often in the news, and U.S. tax compliance has become a part of every bank account opening (and should be considered as part of every offshore structure formation for a U.S. client).
This article describes how FATCA applies and discusses the types of entities that should more closely examine their FATCA responsibilities. You may be surprised to learn that many offshore service providers do not need to register for FATCA (and in fact would receive no benefit for doing so).
The U.S. federal income tax system is generally a “voluntary reporting” system—each U.S. taxpayer is required to file an annual return to report (and pay tax on) such taxpayer’s income for each year. However, as a back-stop to insure that U.S. citizens report all of the income they are required to report, U.S. payors of amounts that could be income to the recipient (e.g., employers, banks, brokers, etc.) are generally required to report such payments to both the IRS and to the recipient. The IRS then matches the reporting by the payor and the tax return filed by the payee to insure that all income is actually reported on a tax return.
These payment reporting requirements obviously do not apply to non-U.S. payors—the IRS has no power to mandate that a bank organized outside the U.S. report interest payments to the IRS. Therefore, before the enactment of FATCA, if a U.S. person were to fail to include interest from a non-U.S. account on their tax return, the IRS would essentially have no way of knowing. The IRS had to rely on one-off, piecemeal, happenstance methods to learn of such accounts, such as searching through the taxpayer’s records or obtaining information from a whistleblower.
The U.S. enacted FATCA to remedy this perceived lack of information. With FATCA, the U.S. obtains information from non-U.S. financial institutions about income paid to U.S. persons by threatening to withhold from certain U.S. source payments made to those non-U.S. financial institutions if they do not provide such information. So, the entire idea of FATCA is to use economic coercion to force non-U.S. financial institutions to provide information about their U.S. accountholders.
To express this in FATCA’s terms, when a U.S. person makes a “withholdable payment” to a “foreign financial institution” (defined further below), FATCA generally requires the U.S. person to withhold (and pay to the IRS) 30% of such payment unless the foreign financial institution has achieved a FATCA-compliant status. “Withholdable payments” currently include only interest and dividends. However, such term will also include (i) the gross proceeds from the sale of stock or debt (beginning in 2017) and (ii) certain foreign payments that are attributable to the receipt of withholdable payments (beginning when the IRS issues final regulations defining this category). Achieving a FATCA-compliant status generally requires the foreign financial institution to provide information about its U.S. owners and accountholders to the IRS.
Similarly, when a U.S. person makes a withholdable payment to a “non-financial foreign entity” (which is any non-U.S. entity that is not a foreign financial institution), FATCA generally mandates the same 30% withholding unless such entity provides information regarding any U.S. persons who own more than 10% of such entity. The payor determines the FATCA status of a non-U.S. entity by requesting the appropriate IRS Form W-8 from such entity.
FATCA Classification of Non-U.S. Entities
FATCA divides all non-U.S. entities into two categories: “foreign financial institutions” (“FFIs”) and “non-financial foreign entities” (“NFFEs”). An NFFE is simply a default category—any non-U.S. entity that is not an FFI is an NFFE. So, the first step in determining how FATCA applies to an entity is to determine whether the entity is an FFI (i.e., an entity that falls into one of the specifically enumerated categories of FFIs) or an NFFE (i.e., an entity that does not fall into any category of FFI).
A non-U.S. entity is an FFI if it is described in any of the following categories:
- The entity accepts deposits in the ordinary course of a banking or similar business (i.e., the entity is a bank or credit union);
- The entity holds “financial assets” (stocks, bonds, and other such assets) for the benefit of one or more other persons as a substantial portion of its business (i.e., the entity is a broker or custodian);
- The entity is a life insurance company that issues cash value life insurance policies or cash value annuities; or
- The entity is an “investment entity,” which is an entity that falls into any of the following three categories:
- The entity is a collective investment vehicle, mutual fund, private equity fund, etc.;
- The entity both (i) derives more than 50% of its income from investing in securities and (ii) has assets that are professionally managed; or
- The entity derives more than 50% of its income from trading, investing, administering, or managing financial assets on behalf of customers.
Again, a non-U.S. entity that is not described in any of the above categories is an NFFE for FATCA purposes.
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FATCA Treatment of FFIs
After determining whether a non-U.S. entity is an FFI or an NFFE, the next step is to develop a FATCA compliance strategy for the entity. This section discusses how an FFI can become FATCA compliant, and the next section discusses the same for NFFEs.
First, an FFI that takes no action regarding its FATCA compliance is a “non-participating FFI”—this is the default category. The FATCA rules and marketplace impose the following negative consequences on non-participating FFIS:
- A U.S. payor of a withholdable payment is required to withhold 30% of each such payment made to a non-participating FFI;
- Non-U.S. financial institutions that are FATCA compliant are required to report to the IRS accounts held by non-participating FFIs; and
- Because of the increased burden and complication, many non-U.S. financial institutions simply do not maintain accounts for non-participating FFIs.
Second, an FFI that is described in one of several specifically enumerated categories can qualify as a “deemed-compliant FFI.” There are two types of “deemed-compliant FFIs”:
- “Registered deemed-compliant FFIs” are those that fall into a specifically enumerated category and must register with the IRS to claim their deemed-compliant FFI status; and
- “Certified deemed-compliant FFIs” are those that fall into a separate list of specifically enumerated categories and can claim their deemed-compliant FFI status simply by certifying as to such status on a form provided to a withholding agent where the certified deemed-compliant FFI has an account.
Only one category of deemed-compliant FFI is relevant for present purposes: An entity that is an FFI only because the entity makes more than 50% of its income from trading, investing, administering, or managing financial assets on behalf of customers can be a certified deemed-compliant FFI as long as the FFI does not “maintain financial accounts.” For this purpose, an entity “maintains financial accounts” when it allows others to deposit money or assets with such entity, uses such assets for some purpose, and repays amounts to depositors/investors upon their request and/or according to the terms of the particular arrangement.
Finally, if an FFI cannot meet any of the specifically enumerated categories for deemed-compliant FFI status, then the entity’s only option to avoid non-participating FFI status is to become a “participating FFI.” Becoming a participating FFI generally requires the following:
- Registering with the IRS as a participating FFI;
- Appointing a FATCA compliance officer;
- Entering into an agreement with the IRS;
- Performing due diligence on accountholders to determine if they are U.S. persons;
- Reporting such U.S. persons (and certain other accountholders) to the IRS; and
- Withholding on certain payments made to certain accountholders.
FATCA Treatment of NFFEs
NFFEs are further divided into the following two categories:
- An “active NFFE” is an NFFE that meets the following two requirements:
- less than 50% of its gross income is “passive income” (i.e., dividends, interest, rents, royalties, and other such income from financial assets). and
- less than 50% of its assets are assets that produce passive income; and
- A “passive NFFE” is an NFEE that is not an active NFFE.
An active NFFE can avoid FATCA withholding simply by certifying as to its active NFFE status on a U.S. withholding form. A passive NFFE can avoid FATCA withholding only by providing information about U.S. persons who own more than 10% of the passive NFFE or certifying that there are no such U.S. persons.
FATCA Treatment of Offshore Service Providers
Now that we’ve made it through all of the FATCA technical jargon, let’s apply these rules to various sorts of offshore service providers to see if they are required to take action to avoid the negative consequences of FATCA.
First, non-U.S. banks, non-U.S. securities brokerages, and non-U.S. life insurance companies that issue cash value policies or annuities are clearly FFIs. They each must (i) carefully scrutinize the list of deemed-compliant FFIs to determine whether they can fall into any category or (ii) register with the IRS as a participating FFI. If they fail to do so, they will lose 30% from each withholdable payment they receive and will essentially be shunned from the global marketplace.
Second, let’s take a look at the FATCA treatment of a non-U.S. company that is licensed to form offshore companies and provide ancillary services related thereto (a “Registered Agent”). The first step is to determine whether the Registered Agent is an FFI or an NFFE. The Registered Agent clearly is not engaged in any of the activities in the first three FFI categories (i.e., it is not a bank, broker, or life insurance company), and it is also clearly not described in either of the first two categories of investment entities (i.e., it is not an investment vehicle, and it derives income from client fees and not from securities).
The final FFI category requires a little more thought—perhaps the Registered Agent could be thought of as earning income from “administering” “financial assets.” Administering is a broad word that potentially covers the activity engaged in by the Registered Agent (i.e., forming and registering an offshore company, insuring that it is properly renewed each year, drafting and filing documents related to share transfers, obtaining certificates of good standing when necessary, etc.), and the stock of an offshore company is undoubtedly a “financial asset.”
However, I believe the better argument is that the Registered Agent is not described in this FFI category. The Treasury Regulations (i.e., the detailed U.S. federal income tax rules regarding the implementation of FATCA) contain several examples of FFIs in this category, and all such FFIs are professional investment advisors and money managers—i.e., entities that run non-U.S. private equity funds or real estate funds, or entities that have discretionary authority to trade assets held by a non-U.S. entity. The Registered Agent’s activities do not rise to the level of the activities described in these examples. Also, an offshore company is more an entity through which the Registered Agent’s clients invest, not the goal of the investment itself. So, it seems strange to treat the stock of an offshore company as the “financial asset” that this category is really looking at.
Therefore, I believe the better argument is that the Registered Agent is an NFFE for FATCA purposes. Furthermore, the Registered Agent should be treated as an active NFFE (as opposed to a passive NFFE) because it does not hold or receive income from financial assets; rather, the Registered Agent is a service provider—its income is from providing services.
As an active NFFE, the Registered Agent essentially has no affirmative obligations under FATCA. If the Registered Agent is ever required to provide an IRS Form W-8 to a bank, then the Registered Agent should appropriately reflect its FATCA status as an active NFFE on such form. Other than that, the Registered Agent is not required to register with the IRS or take any other action, and neither the Registered Agent nor the offshore companies it has formed will be subject to withholding under FATCA or any other consequence due to the fact that the Registered Agent has not registered with the IRS under FATCA.
Taking it even further, registering under FATCA would provide no benefit to the Registered Agent, the companies it forms, or the clients who own those companies—FATCA compliance is concerned only with avoiding FATCA’s negative consequences (i.e., withholding and account closure), so there are no beneficial consequences to be had from attempting to register when registration is not required. Furthermore, the Registered Agent would have a difficult time if it were to attempt to register and become a participating FFI. The registration system and rules regarding what a participating FFI must do are all written assuming the standard fact patterns (i.e., that the participating FFI is a bank, broker, or life insurance company, etc.), so it would be extremely difficult for the Registered Agent to apply these rules to its own situation.
Finally, to double back on my conclusion above—let’s assume that the Registered Agent actually does fall within the definition of an FFI (because, contrary to my conclusion above, the Registered Agent is treated as administering financial assets). The Registered Agent’s treatment as an FFI would have no effects on anyone. The banks where the offshore companies it has formed have accounts will either withhold or fail to withhold on payments of income to the offshore companies based on the FATCA status of the offshore companies, and such status is completely unrelated to the FATCA status of the Registered Agent. The Registered Agent would still not be required to register with the IRS, and any such attempted registration would again be problematic and not beneficial to any party.
The only difference with this conclusion is that, if the Registered Agent is required to provide an IRS Form W-8 to any party (e.g., a bank in which the Registered Agent holds an account), the Registered Agent would indicate that is a certified deemed-compliant FFI because it does not maintain accounts (as opposed to indicating that it is an active NFFE). So, this alternative conclusion simply requires that the Registered Agent check a different box on any IRS Form W-8 it is required to provide.
Finally, if an offshore service provider forms trusts and acts as their trustee in addition to forming offshore companies, FATCA can actually provide an additional revenue stream. Each trust for which this offshore service provider acts as trustee would be an FFI if the trust earns income predominantly from investing in securities (see this article for a more detailed discussion). These trusts would therefore need to become FATCA compliant, whether or not they have a U.S. settlor or any U.S. investments. The easiest path to FATCA compliance for these trusts is for the trustee to “sponsor” the trust for FATCA purposes, which first requires the trustee to register as a “sponsoring entity” (again, this is all discussed in more detail in this article). This is where the FATCA fun really begins!
If you are an offshore service provider that acts as trustee for offshore trusts, let’s discuss how I can help you offer the additional service of acting as a FATCA sponsor for your trusts.