FATCA and it’s far reaching impacts 

Interviewer

The US Foreign Account Tax Compliance Act, commonly referred to as FATCA, is designed to tackle offshore tax abuse by US taxpayers who avoid reporting income to the IRS by investing through offshore accounts and/or entities.

The regime requires foreign financial institutions to identify the direct and indirect owners of their accounts to determine whether the accounts are US accounts under the FATCA rules. If so, the bank must disclose the account to the IRS.

There seems to be a lot of misunderstanding among the world’s financial institutions about how these rules apply. Many think the rules don’t apply to them because they don’t have any US investors.

But in fact, when FATCA takes effect on 1 January 2013, it will impact any fund or investment manager who invests in US assets on their clients’ behalf, no matter where their clients are located.

Joining me today to clarify these requirements and discuss some of the latest IRS guidance are Richard Hinton, an Audit Director with KPMG in the United Kingdom, and Georges Bock, a Partner with KPMG in Luxembourg, and Laurie Hatten-Boyd, a Prinicipal with KPMG in the United States.

Interviewer

To begin, we’ve noted that there is a lot of confusion about the rules, and this could cause a number of non-US financial institutions to fail to comply, while others might choose not to. What are the consequences for those who don’t meet their obligations under FATCA to disclose their US accounts?

Richard

The IRS quite explicitly wishes to eliminate the opportunity for tax evasion; to eliminate the opportunity for entities to become blockers that US taxpayers can hide behind and that core principle will pervade the financial services industry. So, we spend a lot of our time, Georges and I particularly, helping investment management clients to implement this. We spend a lot of our time trying to dispel myths, particularly clients and one of the classic myths is that compliance is somehow a choice because when you actually lift the lid on this and start applying it to financial institutions you realize there are very few entities out there, really, where compliance is a sensible, or non-compliance is a commercial proposition.

Georges

Yes, I would agree on that. More specifically because it will have a disastrous impact on the return of the US investment and the rules which require 30% withholding to be made on all withholdable payments meaning all payments coming out of the US under these definitions and that would, of course, reduce the return dramatically and that's also a simple reason why this is not acceptable, not to individuals nor to the investment management community.

Laurie

That's right and just to add to that 30% penal withholding on the withholdable payments, one of the biggest reasons that foreign financial institutions are going to commercially need to comply is the pass-through payment provision and if the IRS and Treasury don't change the way those are drafted now or the concept that they’ve set forth where now we're going to have that penal withholding on non US source income as well, to a certain extent. That is a very big stick in this area.

Interviewer

That’s a lot of information to sort through. What are some of the most important aspects of this guidance?

Laurie

I think based on the second subsequent notice that came out, notice 2011 – 34, there were really three driving forces there that are critical at this point. And one is the clear change in the documentation rules; we've seen what they’re changing with respect to pre-existing individual accounts and we've heard from their speaking publicly that they are changing the other documentation rules, so that’s certainly critical. The other critical piece is the new definition of pass-through payments, or I shouldn’t say new, all we had was the statutory definition which didn't really tell us what IRS and Treasury were going to believe that end attributable to a withholdable payment how far they were going to take that and clearly with the definition they took it as far as they possibly could. And then the third key critical issue right now is the deemed compliance status. Right now, they gave us some new ideas of entities that they're thinking would fall within that classification that we've got such onerous requirements that there's very few entities, if any, at this point across the globe that would fit within that. So, for me, it's those three key points that we're all, kind of, focused on right now.

Richard

I think from my perspective, when I'm talking to a client, I suppose, they're asking the question, is this going to a) going to cost me more money, so its cost and compliance really going to hit me but also where commercially is this really going to put a threat to my business model. And on the cost of compliance, I think the aspect that really concerns people is the extent to which they are going to have to do due diligence over existing customer base and also the extent to which they are going to have to build the plumbing required to generate the reporting for the IRS and potentially to flag and withhold on ultimate withholdable payments. On the commercial side, I think certainly for the investment management industry there are some very real concerns about the consequences of this regime on various business models.

Interviewer

Next let’s talk about the rules for pass-through payments. How will these rules apply?

Laurie

The pass-through payment provision is something that was in the statute. The whole point of the pass-through payment was to get at a particular fund that, maybe, that’s the beneficial owners, so it’s a corporation, and it can invest in US Treasuries, for example, take advantage of the portfolio interest exceptions, so it's getting a zero rate of withholding on its interest, and can immediately distribute a foreign source dividend and so a US person could invest in that type of fund and completely escape both disclosure and any of this penal withholding. So, they put this provision in the statute to, kind of, close that gap and we were all waiting to see what, exactly, IRS and Treasury would do with this and then, of course, they came out with this concept where it was construed as broadly as possible and that, as Richard has pointed out, that there would be this ratio of the foreign financial institutions’ US assets to its total assets and that ratio would be applied to any payment that didn't fall within the definition of a withholdable payment and to the extent of that ratio there would be withholding. So, a very complicated concept; it certainly works on paper and theory, but in an automated payment process, interjecting this very manual process is just truly not workable. And then, certainly, the United States imposing withholding on income that’s not source to it, there's a conflicts of law question here that needs to be resolved. I mean, this is something that certainly goes beyond the bounds of any sovereign nation to date and so we’re all very interested and we do know that other governments are in conversation with the United States about this exact issue.

Georges

Yes, I would join in saying well, of course, the way the whole principles have been construed are very complex and I compare that, for example, to the savings directive where all the ratios have to be calculated and where the industry is used to the kind of ratio calculation. However, one has to say that the pass-through payment concept, as it is developed right now, is by far more complicated. More guidance is also needed, for example, for umbrella funds and similar kinds of products which are our daily bread right now and where people need solutions and I would also come to Laurie's point in saying, okay, the pass-through payment concept would not only make that there is withholding tax on withholdable payments but also on other non-US source income and where some people start to have a headache, as a matter-of-fact, is that it might well happen that in the application of these rules, by default, some that are non-US taxpayers because they are not, maybe, documented along all the rules that would be required by FATCA, because FATCA rules are for identification of clients and money-laundering rules slightly differ,  so what it could bring to them would be a withholding tax. Now, if that is happening, and it happens to non-US person because he is not fully documented along the FATCA rules, he would not only suffer tax on US soil's income but also on other worlds, European and Asian income, and it's a very good question, if he cannot attack the investment managed industry and the fund promoter saying, look, you have unduly withheld withholding on my revenue and this is, of course, a headache from a risk perspective because if that comes to, most probably, a situation before court it could be that a judge would say, look, I can understand that nobody can force you to pay US tax on non-US income and you'd have a hell of a lot of matters which would have to be dealt with within the industry going forward from here.

Interviewer

Can you elaborate on what types of institutions might be “deemed compliant” under the new FATCA rules?

Laurie

I think this is another area where, I think, it's encouraging what we're seeing from Treasury and IRS, that they're taking the right step with this risk-based approach but, again, just as with the documentation rules, we're seeing these requirements added on at the end where it's just next to impossible, as currently drafted, to conceive of an entity that’s going to be able to meet the requirements. But, some of them that we're seeing, there's one from the first notice where it was for entities with small identified owners and the example given was a small family trust where they would actually give up all the documentation for the owners to the US withholding agent or to a participating FFI if that’s who this entity had an account with. And really what this is, is a documented FFI, it’s just that the concept is that they're so small that compliance would be overly burdensome to them so they just letting them fully disclose. Then we see some for banks either where every entity in the group is limited to this very local market and they don't solicit business outside the market. And then there's a very similar type deemed compliant status where one entity in the group keeps their business to a very local market and the concept here really is that these types of local foreign financial institutions don't really offer the products and services that a sophisticated tax evader would be looking for. And then we also have one in the fund group where they have talked about where the fund, where all of its direct owners are either participating FFIs, deemed compliant FFIs, or what we call the 1471F entities and that's the governments, the foreign central bank of issue, really entities where it would be next to impossible for a US person to use such an entity to evade tax. I think we've also heard some talk about funds that prohibit US owners and I do know that there definitely is some traction with that. Right now I know that IRS and Treasury are struggling. Right now, in the prospectus, the way those are drafted, the definition of a US person is an SCC definition which differs from a tax definition and so they’re concerned that US people still could own these and technically they could through a series of partnerships and what-not and meet the definition. But right now, those are the ones we're seeing but again, we see so many requirements added on that it’s next to impossible, I think, for any of these entities that I just talked about to be able to use the deemed compliant status but I do know that there were significant push back to Treasury and IRS and so we expect, when we see the proposed regulations, to definitely see some relaxation in that area so that more entities…because certainly that's what they're looking for is to get these entities deemed compliant.

I am very encouraged by the conversations that we’re having and hearing with both Treasury and IRS officials on this, in particular, this deemed compliant area where we're hearing things that, I agree, a very pragmatic approach seems to be, the direction that the taking and just from the conversations, again, I think it's very clear that they’re very keen on developing a workable regime and it seems, you know, like they’re really listening to industry.

Georges

A maybe, like always in the world, the truth is in the middle so there would be moves from both sides. Laurie, you pointed out that the US restriction right now in the European fund industry, for example, as a matter of fact they are SCC orientated but maybe the industry has then to accept to widen those concept into the US taxpayers instead of just people really living physically on the territory of the United States and maybe that industry has to move but if the IRS is open to the concept of restricting these kinds of investors that could be a move forward but here, also, just mention like the devil is always in the detail, for example, in some countries you would, from a legal perspective, not be allowed to exclude a certain kind of category of investors to funds if your product is retail it has to be offered to everybody so it's easily said but not as easily done but I believe the industry has to make a move. But definitely, also, I believe the IRS has to make a move to make the whole thing more pragmatic and more specifically into one category of activity which is the global distribution of funds, so in Europe there is the single market which is reality in the investment fund industry which means that very often people operate one platform in one country and from that they distribute in the entire European Union under the single passport. Now if you look at deemed compliant the concepts, very often they speak about domestic markets and domestic markets in that perspective means then very often the national market, the country, however, under the concept of a single market and a single passport, whereby you can sell your products to the entire union, for example, these kinds of restrictions are not very useful so hopefully their pragmatic approach would go more in that direction that, for example, markets like the single European market are recognized as one territory versus the domestic market which is then a country specific market.

Interviewer

I understand certain investment vehicles may also be “deemed compliant”.

Georges

I think what is very important there, as an introductory remark, is I very often hear our from our customers and from people in the industry, they speak about deemed compliance as if we would speak about exemption and that is, I think, a misunderstanding which is very important to point out. If somebody is deemed compliant that does not mean he is exempt so he nevertheless would have to do certain things as well as comply with certain rules and take the responsibility for complying with certain rules and, for example, the pass-through payment calculation could be one of them as far as the investment funds are concerned but also make sure that at all moments you still fulfill the requirements of being deemed compliant, I believe, would nevertheless mean that all deemed compliant, for example, funds would have to make sure that the distributors are all PFFIs so they are all in the category of allowing them to have this deemed compliant status.

Richard

I agree with George. For me, the challenge of this deemed compliance is that contingent risk; the idea that you are still on the hook. If some point in the future you fail to, your vehicle or your entity fails to qualify for any of these kinds of special exemption categories you face the full contingent risk of the vehicle becoming or being required to be fully FACTA compliant in a short period of time in order to avoid catastrophic withholding from market counterparties. And I think that contingent liability is going to drive significant compliance cost and significant compliance implementation regardless of the extent to which your entities qualify for these lighter touch compliance statuses.

Interviewer

Richard, Georges and Laurie, thank you all for bringing clarity to these new requirements. Before we conclude, do you have any closing comments?

Richard

I suppose the conversations I'm having with clients right now really are about what we can do in the coming months. There’s a lack of clarity about the regulations, we're hearing very sympathetic noises coming out of the authorities about how they’re going to try and make the regime operate; workable, but until we see you’re somewhat paralyzed in terms of actually designing in any level of detail your compliance model for the future. The clients are asking me what can I do in the meantime; should I just sit on my hands and ignore it six months? And my answer to that is that there are still some real commercial and reputational risks that need to be understood. You need to do your due diligence over in the funds industry, distribution channels; to understand exactly where your commercial risk lies; which service contracts, which service providers, which outsource providers etc you need to engage with so that when we get clarity on the rules and you can start building your compliance model you're not starting on the back foot; you've got a good idea about where your firm and your operating business model is vulnerable to this regime.

Laurie

And I think just to add-on that, you know, clearly, as Richard pointed out, these rules remain very fluid and it's very difficult until you get definitive guidance to get too far down the road towards compliance because you don't want to spend a lot on re-work. But that being said, even with the latest notice with a little bit of transition relief in terms of dates, if entities don't know exactly the extent to which they going to be impacted, really getting at knowing sufficiently to get a budget in place so that when the definitive guidance does come out they can just immediately go into action mode. Even with that transition relief they will never be FATCA compliant in time unless they get to that point right now that they have every place identified, as Richard said, in the funds industry; which contracts are affected, which distribution chains; all of that. If that's not identified right now, the work that can be done now truly does need to be done now otherwise from the time the definitive guidance comes out until that  January 1st, 2014 possible withholding date, it’s just not going to be put in place timely; it just can’t be.

Georges

I think people would absolutely have to take advantage right now of the time. I mean, even though there has been this phasing in of the six months further postponement, kind of postponement, what is going to be key is, really, raise awareness in the entire organization that people are part of. We need to make sure that everybody has understood and everybody contributes to what is also important is that reduced complexity and there’s a kind of visibility that would be created and in that sense there really status analysis is made of organizations and how they operate but also, what we also see more and more are different players in the industry, be it the transfer agents, be it the distributers, be it the investment funds or be it the custody banks; everybody looks for the other person to start communicate their plans, to speak about how they would like to deal with the issue and that is something which would also require, from a commercial perspective, that people are starting now to position themselves, or at least give a, kind of, first positioning. And then I would say last but not least, really also really apply that to your business model because this is not only a tax issue it is really an operational strategic and commercial issue, as also pointed out earlier on. You have to speak and you have to communicate with your distributors and see what is going to be their reaction. You have maybe to adjust your product chain and the services offered and so on. And so it's really these kind of things; they are absolutely to be done right now and full implementation will be done when the rules are clear but before that it is important to be prepared.

Interviewer

Listeners can find more details on this topic in the September 2011 edition of KPMG’s frontiers in tax publication

Previous podcasts in this series include tax professionals from KPMG in the UK and Hong Kong discussing how regulatory change around the world is affecting the insurance industry, particularly in Europe and the Asia Pacific region.

Our next podcast includes KPMG Tax partners from the United States, the UK and Japan will provide their perspectives on tax reforms in their countries aimed at increasing tax revenues from the offshore profits earned offshore by domestic multinationals.

Thank-you and we look forward to you joining us next time.