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 , 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 (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% 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 jurisdictions, such as the Cayman Islands, have these agreements in place.

During the registration process, each institution receives a , 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 submissions.

The U.S. government has negotiated agreements with numerous countries to help implement FATCA more smoothly. These 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 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 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 "." 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 "," 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 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 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 "," 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.

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 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 "." 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 , known as CRS.

This framework requires institutions to conduct investor 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.