FATCA

The Foreign Account Tax Compliance Act is a comprehensive U.S. law designed to stop tax evasion. The law targets a specific problem: U.S. citizens and residents hiding money in foreign accounts to avoid paying taxes.

To solve this problem, FATCA requires foreign financial institutions to report information about accounts held by U.S. taxpayers. This includes offshore funds Offshore fund An offshore fund is a hedge fund established outside the United States, typically in low-tax jurisdictions like the Cayman Islands or British Virgin Islands. These funds primarily serve non-U.S. investors and U.S. tax-exempt organizations by offering tax advantages and greater regulatory flexibility than domestic fund structures. , which typically qualify as foreign financial institutions under the law. These institutions must follow extensive reporting and withholding requirements or face serious penalties.

Investment vehicles like CLOsA structured debt security backed by a pool of commercial loans, typically used by institutional investors. (collateralized loan obligations) generally qualify as foreign financial institutions under FATCA when they are organized outside the United States. This classification triggers important obligations.

These entities must register with the Internal Revenue Service and set up reporting procedures for their U.S. account holders. This includes both investors who own debt and equity in the funds. If they fail to comply, they face a 30% withholding taxTaxes deducted from payments at the source, particularly relevant for foreign investors or entities receiving U.S.-sourced income. on certain types of income they receive from U.S. sources.

Foreign financial institutions have two main paths to comply with FATCA requirements. They can either enter into a formal agreement with the IRS for direct reporting, or they can follow local reporting requirements in countries that have established agreements with the United States. Many popular offshore Offshore fund An offshore fund is a hedge fund established outside the United States, typically in low-tax jurisdictions like the Cayman Islands or British Virgin Islands. These funds primarily serve non-U.S. investors and U.S. tax-exempt organizations by offering tax advantages and greater regulatory flexibility than domestic fund structures. jurisdictions, such as the Cayman Islands, have these agreements in place.

During the registration process, each institution receives a global intermediary identification numberA unique identifier assigned by the IRS to foreign financial institutions that register under FATCA, used for reporting and compliance purposes., known as a GIIN. Think of this as a unique identifier, similar to a social security number for the institution. The institution provides this GIIN to other parties through self-certification forms and official IRS paperwork called Form W-8IRS forms used by foreign persons to certify their foreign status and claim treaty benefits or exemptions from withholding. submissions.

The U.S. government has negotiated agreements with numerous countries to help implement FATCA more smoothly. These intergovernmental agreementsBilateral agreements between the U.S. and foreign governments to facilitate FATCA compliance and resolve conflicts with local laws. come in two main types, known as Model 1 and Model 2.

Model 1 intergovernmental agreements typically relieve foreign financial institutions from entering individual agreements with the IRS. Instead, these institutions report U.S. Reportable PersonsUnder FATCA, U.S. persons and foreign entities controlled by U.S. persons that must be identified and reported by foreign financial institutions. to local tax authorities in their own countries. For example, institutions organized in the Cayman Islands report to the Cayman Islands Tax Information Authority while maintaining separate local registration requirements.

Model 2 intergovernmental agreements provide different types of relief. They help resolve conflicts between local privacy laws and FATCA requirements, and they provide relief from certain withholding taxes. However, institutions covered by Model 2 agreements must still enter into and comply with direct IRS agreements.

The United States has established intergovernmental agreements with countries worldwide, making compliance more manageable for institutions in participating jurisdictions.

Foreign financial institutions must create procedures to identify their account holders. Specifically, they need to determine whether account holders are U.S. personsIndividuals or entities subject to U.S. jurisdiction for securities law purposes, including U.S. citizens, residents, and entities organized under U.S. law. or foreign entities controlled by U.S. persons. The law calls these individuals "U.S. Reportable Persons."

Unless specific exemptions apply, institutions must report identifying and account information for these individuals to the appropriate government authority. They also must report information about account holders who refuse to cooperate with the institution's identification procedures under FATCA. This reporting requirement ensures the U.S. government can track accounts that might be used for tax evasion.

FATCA applies to two main categories of payments, which the law calls "withholdable paymentsUnder FATCA, certain U.S. source payments subject to 30% withholding tax if made to non-compliant foreign financial institutions.." Understanding these categories helps explain when the 30% penalty tax might apply.

The first category includes U.S. source payments of various types of income. This covers interest payments (including original issue discount and portfolio interest), dividends, rents, salaries, wages, premiums, annuities, compensation, and other regular income. The tax law refers to these collectively as "FDAP Payments FDAP income Fixed, Determinable, Annual, or Periodical (FDAP) income is a specific category of investment income that comes from U.S. sources. This includes dividends from U.S. companies, interest from U.S. bonds, and similar types of passive income. When foreign individuals or entities (including offshore hedge funds) receive this type of income, they must pay a 30% withholding tax to the U.S. government, unless they qualify for a reduced rate through tax treaties or specific exemptions. ," which stands for "fixed or determinable annual or periodical" payments.

The second category originally included gross proceeds from sales of property that could produce U.S. source interest or dividends. However, proposed Treasury RegulationsOfficial interpretations and implementing rules issued by the U.S. Treasury Department for federal tax laws. from December 2018 eliminated this withholding requirement on gross proceeds, and taxpayers can rely on these proposed rules.

Some payments fall outside the withholdable payment definition entirely. These exceptions include income that is effectively connected Effectively connected income (ECI) Income earned by foreign individuals and companies that has a strong enough connection to a U.S. trade or business to be taxed like domestic income. Instead of paying a simple flat withholding tax, foreign persons with ECI must pay regular U.S. income tax at graduated rates and can claim deductions, just like U.S. taxpayers. with a U.S. business and certain non-financial payments.

Foreign financial institutions face additional complexity when they make payments to account holders that relate to the U.S. source items described above. These payments are called "foreign passthru paymentsPayments made by foreign financial institutions to account holders that are attributable to U.S. source income, subject to FATCA reporting and withholding.," and institutions must implement similar reporting and potentially withholding procedures for them.

The government has not yet provided a precise definition of foreign passthru payments, though they are expected to include payments made by institutions to their shareholders and debtholders. The reporting and withholding requirements for such payments will not take effect until two years after the government publishes final regulations defining the term.

Domestic funds Domestic fund A domestic fund is a hedge fund organized under U.S. law—typically as a Delaware limited partnership or limited liability company—that serves as the primary investment structure for U.S. taxable investors. face different requirements than their foreign counterparts. Currently, domestic funds must withhold on withholdable payments made to foreign financial institution investors or other foreign entity investors. However, they can avoid this withholding if they obtain appropriate beneficial ownership information and valid certification that the investor is compliant with FATCA requirements.

Foreign financial institutions that properly fulfill their FATCA obligations can avoid the full 30% withholding tax burden. However, they still have ongoing responsibilities that require careful attention.

These institutions remain responsible for identifying U.S. Reportable Persons among their account holders. They also must implement withholding procedures for individuals who fail to provide required FATCA information or who cannot provide necessary waivers from bank secrecy lawsFederal law requiring financial institutions to assist U.S. government agencies in detecting and preventing money laundering. in their home countries. Institutions can delegate this withholding responsibility to other parties, but they remain ultimately responsible unless an applicable intergovernmental agreement addresses these privacy law conflicts.

Account holders who fail to meet these requirements receive the classification of "recalcitrant account holdersUnder FATCA, account holders who fail to provide required documentation or waive bank secrecy laws, subject to withholding on their accounts.." This designation typically results in withholding on payments to their accounts.

An important limitation affects offshore funds that face FATCA withholding. Taxes properly withheld under FATCA generally cannot be refunded or credited to offshore funds that do not reside in countries with tax treaties with the United States. This makes compliance even more important for these institutions.

FATCA operates alongside similar international efforts to combat tax evasion. More than 100 countries, including most jurisdictions where hedge funds commonly organize outside the United States, have committed to implementing the OECD Common Reporting StandardOECD international standard requiring financial institutions to identify and report account information for foreign tax residents to their local tax authorities., known as CRS.

This framework requires institutions to conduct investor due diligenceThe comprehensive investigation and evaluation process conducted before making an investment or business decision. and provide annual reporting on certain investors who are residents of participating countries or controlled by such residents. While similar to FATCA in purpose, CRS represents a broader multilateral approach to information sharing for tax purposes.