FATCA and its impact on foreign banks – now it gets serious

Read our article in the Cayman Financial Review Magazine, eversion 

The Internal Revenue Service (IRS) has announced they are on track to issue proposed FATCA regulations in December 2011 (if the IRS miss their announced deadline we expect the guidance will be released before 31 January, 2012), with registration required by 30 June, 2013.

When the regulations are released there will be enough certainty on the rules to permit financial institutions to begin a comprehensive evaluation of the effect to their business lines of the new FATCA legislation. More importantly, with less than a year and a half until the registration deadline, the time for implementation will be a concern.  

This article will provide an overview of FATCA and outline how the banking industry will be impacted by this new legislation.

  • $100 billion
     – the amount currently lost to US persons with undeclared accounts
  •  30 per cent
    – the amount of withholding tax exposure for FFIs that do not agree to identify account owners
  •  363 per cent
    – the increase in total US source income between 2000 and 2007

Source: Senate Congressional Record, S1745, Hire Act, Senator Levin, 18 March 2010 

What is FATCA?

The Foreign Account Tax Compliance Act was enacted into US law on 18 March, 2010. The legislation is designed to curtail certain offshore tax abuse by US taxpayers that are currently able to avoid disclosure to the IRS by investing through offshore accounts or entities.

The core principle of these new reporting rules is the requirement that a Foreign Financial Institution will need to enter into a disclosure agreement with the IRS, agreeing to identify the direct and indirect owners of its accounts to determine whether they are “US accounts”.

To the extent they are US accounts, the FFI must disclose them to the IRS. FFI’s that refuse to enter into these disclosure agreements will suffer a 30 per cent withholding tax on all US withholdable payments.

The fear tactic the IRS is using to ensure registration is a withholdable payment, which also now includes the gross proceeds on the sale of a US bond or stock. From a business perspective, no institution or investor can lose 30 per cent of the gross proceeds on the sale, for example, of IBM common stock.

It is important to note the FATCA provisions are additional to and not a substitute for the current US withholding regimes already in place. Under the new FATCA law, a 30 per cent withholding tax is applied on all withholdable payments (interest, dividends and most notably gross sales proceeds from the sale of US investments including bonds/securities, derivatives and Notional Principal Contracts) made to a FFI, unless the FFI signs a disclosure agreement with the IRS to be a “participating FFI”.

The disclosure agreement will require the PFFI to the following actions:

  • Obtain information regarding each account holder to determine which (if any) of such accounts are US accounts.
  • Comply with extensive verification and due diligence procedures required by the IRS/Treasury with respect to the identification of US accounts.
  • If the FFI maintains US accounts, it must report on an annual basis certain account information to the IRS.
  • The FFI must deduct and withhold a tax equal to 30 per cent on certain payments to recalcitrant (non-responsive) account holders and non-participating FFIs.
  • A FFI must comply with requests by the IRS/Treasury for additional information with respect to any US account.
  • If foreign law prevents the reporting of any information, the FFI must attempt to obtain a waiver from relevant account holders in a reasonable time period or close the accounts.


Scope of financial accounts

The statute provides that a financial account includes a deposit or custody account. There is currently a small exemption for deposit accounts with a balance of US$50,000 or less as well as other accounts that have not been identified as US accounts with the same threshold.

One of the focus points in the customer account review will be on private bank accounts with assets greater than US$500,000. The rules require the PFFI to aggregate balances in numerous accounts held throughout the affiliated group by the same account holder for the purposes of the threshold(s).

Who is impacted in the banking industry? 

  • Any bank or other financial institution invested in the US market for either its customer’s accounts or its own account.
  • Due to the affiliated group rules, any bank which is part of a group which invests in the US market for its customers’ accounts or for its own account.
  • Pending final guidance from the IRS – potentially any financial institution that does business with FATCA compliant banks.


What are the challenges for the banking industry?

From our perspective the key issues a bank will likely encounter with the implementation of FATCA are:

  • Performing a strategic analysis on whether the bank remains invested in the US market for its customers’ accounts or for its own account.
  • Consider whether the bank will continue to maintain or withdraw contact with US account holders. For example, HSBC announced in July 2011 that it will stop offering services to US clients from locations outside the US.
  • Analysing the potential impact of FATCA non-compliance and determining a compliance strategy.
  • Banks need to understand the value chain in order to ensure all counterparties are participating FFIs. This is very important given the requirements of the controversial pass-through rules.
  • Implementing the withholding and compliance provisions within the tight deadline. The FATCA reporting requirements apply to certain payments beginning 1 January, 2014. This is a challenging deadline considering that banks will need to undertake a full impact analysis and implement new operating procedures (KYC documentation etc) and significant changes to their IT systems to be able to complete the reporting.
  • Obtaining waivers from all US customers in order to report to the IRS in those jurisdictions where privacy laws prohibit exchange of information without consent.
  • Banks will need to analyse their service offerings to identify which products will be affected by FATCA. There may be complexity in some products that at first glance are deemed out of scope, eg credit cards, investment vehicles with mortgages etc.
  • Product terms and conditions may need to change (eg gross-up clauses in financial contracts for withholding taxes).
  • Banks will need to ensure their IT systems are capable of identifying where they may make withholdable payments eg derivatives, debt instruments etc.
  • Remediation of banks’ back book (client identification system) is made more difficult by the number of customer systems and data that requires updating.
  • Changes may be required to the compliance framework within the foreign bank to support the nomination and powers of a chief compliance officer who will certify to the IRS that the bank is compliant with the FATCA requirements.


What has to be done – key dates? 

  • 1 January to 30 June, 2013
    Registration with the IRS to be a participating foreign financial institution.
  • 1 January, 2014
    First phase of reporting and withholding on certain specified payments including US source interest and dividends takes effect.
  • 1 January, 2015
    Second phase of implementation of the reporting and withholding requirements takes effect. On this date PFFI’s must begin to report and withhold on US gross proceeds.

Considering the wide-ranging impact of the new FATCA legislation, a bank wanting to either maintain relations with US clients or remain invested in US securities on behalf of its non-US clients will not only have to comply with FATCA but also with other applicable regulations.

The impact on the banking industry is significant. These are complicated rules and the terminology involved is akin to a foreign language. As a result, assistance will be required from specialists. Compliance may force changes to a banks’ core strategy and business model.

It is essential that all financial services companies, including banks, thoroughly review and understand the potential implications, as well as create a strategic response. With proposed FATCA regulations due now, it is important that banks are adequately equipped to act promptly so they are in a good position to meet the tight timeline (30 June, 2013) for compliance.

The FATCA rules are very complex and it is advised that affected entities should consult with their tax or legal advisors. Due to the scope of this legislation and the numerous changes required an advisor with a strong global network is needed.

Simply put, most financial institutions will require a dedicated global multi-disciplinary team to assist them in helping to assess the cross border requirements of FATCA and the impact this will have on their organisation.