On 27 June 2014, the Internal Revenue Service (IRS) released Revenue Procedure 2014-39, containing an updated and final QI Agreement to replace the prior version set forth in Revenue Procedure 2000-12. Many of the modifications to the new Agreement relate to harmonizing a QI’s requirements under chapters 3 and 61 of the Code to its chapter 4, Foreign Account Tax Compliance Act (FATCA), requirements. Notwithstanding certain fundamental modifications to the prior QI Agreement, the IRS did not issue the new agreement in draft form. Highlights:
- Renewal: pursuant to the new Revenue Procedure, all existing QI Agreements expired on 30 June 2014, (including those that were in full force and not in existence under the automatic extension until that date) and must be renewed immediately. The Revenue Procedure is silent as it relates to the period between 1 July 2014, and the date that the QI’s Responsible Person has internal approval to enter into the new agreement with the IRS.
- Requirement that, as part of the QI Agreement, the QI must be “materially” compliant with respect to the payments it makes as a nonqualified intermediary (NQI).
- Modification of the definition of “Reportable Payment” for non-U.S. payors:
- Elimination of the rules for Undisclosed U.S. Persons
- Elimination of the ability for non-U.S. payors to enter into an agreement with another withholding agent to report Reportable Payments that are not Reportable Amounts (previously defined as “Designated Broker Proceeds”) on the QI’s behalf.
- Limitation on the type of entity that can qualify as a Private Arrangement Intermediary (PAI).
- Limitation on the partnership/trust “joint account” rule.
- Changes relating to due diligence failures as well as presumption rules in the absence of valid documentation.
- Requirements relating to pooled reporting.
- Changes in compliance requirements.
- Changes for QIs that are Nonfinancial Foreign Entities (NFFEs)
Requirement to be Compliant when acting as a Nonqualified Intermediary (NQI)
The original QI Agreement covered a QI’s responsibilities solely when it was acting as a QI. Specifically, the Agreement was limited to the payments made to an account that the QI had designated as a QI account with its upstream withholding agent. Notwithstanding that, the IRS did, on occasion, request the QI’s external auditor to review reporting (in particular, Form 1099 reporting) with respect to income that was paid to an account that the QI had not designated as QI account. From a practical perspective, because the external audit was an agreed upon procedure, the external auditor was unable to look into the QI’s compliance in areas that exceeded the scope of the steps set forth in Revenue Procedure 2002-55 (including responding to follow-up questions pertaining to “certain numerical results” set forth in the submitted audit report).
Seemingly in response to this, the new QI Agreement provides that, as part of the Agreement, the QI “must . . . materially comply with the requirements of a withholding agent or payor, as applicable to a nonqualified (foreign) intermediary under chapters 3 and 61 and section 3406, for any account for which it does not (or cannot) act as a QI and for any payee that is not an account holder.” This is a fundamental change. While under the old Agreement, the IRS had the right to terminate the Agreement for a variety of failures, it had limited visibility into the QI’s compliance level relating to activities outside the scope of the Agreement. Given this modification, the IRS will now be able to more easily obtain information that relates to the QI’s compliance with respect to those other activities.
Elimination of the Undisclosed U.S. Person Concept/ Modification to the Definition of “Reportable Payment” for Non-U.S. Payors
When the QI Agreement was initially drafted, the IRS and prospective QIs operating in jurisdictions with robust data privacy laws struggled to find a balance between the IRS’s desire to have information relating to U.S. persons with offshore accounts and the QI’s inability to provide certain information without violating local law. This resulted in the provisions relating to “undisclosed U.S. persons.” For these persons, backup withholding was required on income, as well as proceeds from the sale of a U.S. asset, regardless of where the sale was effected. This was based on the definition of a Reportable Payment provided in section 2.44 of that Agreement. (Reportable Payment for a non-U.S. payor included all proceeds from the sale of an asset that could generate a reportable amount, regardless of where the sale was effected).
In light of FATCA’s new reporting requirements for U.S. accounts, the new QI Agreement eliminates the provisions relating to undisclosed U.S. persons. In addition, it redefines a Reportable Payment for a non-U.S. payor. Specifically, new section 2.73(B) now provides that, for a non-U.S. payor, a Reportable Payment includes any broker proceeds (not just those relating to U.S. securities) if the sale is effected inside the U.S. For this purpose, however, the sale is generally not effected inside the U.S.
Under FATCA, the IRS should now receive the account reporting for U.S. persons that had previously refused to be disclosed. It will not, however, receive any FATCA withholding on proceeds until 1 January 2017 (and, even then, it will be limited to proceeds on assets that generate U.S. source interest and dividends). Consequently, given the change in the Agreement, a person formerly classified as an undisclosed U.S. person that holds an account with a QI that is a non-U.S. payor can now sell both U.S. and non-U.S. securities held in that account without the imposition of withholding, as long as the sale is effected outside the U.S. before 1 January 2017.
Further, the new Agreement modifies the same QI’s ability to enter into an agreement with another withholding agent whereby that withholding agent could agree to report, on Forms 1099, the QI’s Reportable Payments that are not Reportable Amounts made to U.S. non-exempt recipients (namely, this would have been foreign source income paid inside the U.S. or proceeds from sales effected in the U.S. where the QI elected Forms 1099 instead of FATCA’s Form 8966 account reporting). Specifically, under the prior agreement, a QI remained responsible for the reporting of these amounts (formerly defined as “designated broker proceeds”) even when it did not assume primary Form 1099 reporting and backup withholding responsibilities but was permitted to enter into an agreement with another withholding agent whereby that withholdable agent would take on the responsibility.
In the revised Agreement, only a QI that is a U.S. payor has this option. Presumably, this is because the non-U.S. payor may now certify that it has filed Forms 8966 for its U.S. accounts and, in doing so, eliminates its Form 1099 reporting obligation. However, the new limitation for non-U.S. payors overlooks the fact that the QI may have elected Form 1099 reporting in lieu of FATCA’s account reporting.
Private Arrangement Intermediary (PAI) Limitations
Another modification is found in the new limitation for the types of entities that are eligible to enter into PAI Agreements. PAIs are intermediaries that receive U.S. source income on behalf of their account holders but, instead of entering into a QI Agreement with the IRS to act as a QI, they enter into a PAI Agreement with the QI for whom they act as a PAI. In effect, the PAI agrees to comply with the same documentation and due diligence procedures applicable to the QI but the PAI does not report directly to the IRS.
Instead, the QI for whom the PAI is acting includes the PAI payment information with its own direct account reporting pools (and indirect recipient specific reporting). Significantly, the QI remains liable to the IRS for any failures of its PAI(s). Under the prior Agreement, there was no limitation on the type of entity that was eligible to act as a PAI.
Interestingly, the new QI Agreement limits the type of entity that can enter into a PAI Agreement to a certified deemed compliant FFI (other than a registered deemed compliant Model 1 IGA FI). It is not known why the IRS placed restrictions on the types of entities that can enter into a PAI Agreement. More problematic, however, is the timing. As indicated above, the QI Agreement was released with very little time for impacted entities to react (one business day). There are many entities that were previously acting as PAIs that do not meet the new requirements. Moreover, they do not have systems set up for QI reporting. With the lack of notice, it is unclear how such entities will be able to convert to QI status in a timely manner.
Limitation on the Joint Account Rules
Similar to the unexpected limitation on entities that can qualify for PAI status, the new QI Agreement has a similar unexpected limitation on the types of entities that can qualify for the so-called partnership/trust joint account solution (former Section 4A.01). The purpose of the solution was to accommodate situations where the QI could obtain adequate documentation to support the non-U.S. status for the partners or beneficiaries (or owners) of a foreign partnership or simple (or grantor) trust that was a direct account holder of the QI but where local law prohibited the QI from complying with the requisite recipient specific Form 1042-S reporting for those underlying owners.
Under the prior requirements, as long as no underlying owner was a U.S. person and the “joint account” partnership or trust provided, among others things, all underlying owner documentation and agreed to provide its partnership or trust agreement establishing that such documentation was complete, if requested, the QI was able to apply the joint account provisions. Specifically, while those provisions required the QI to withhold at the highest applicable rate for any one partner or owner, they permitted the QI to include the payments to the partnership or trust within its own pooled reporting.
Unfortunately, the new QI Agreement further restricts the use of this rule to a partnership or trust that is a “certified deemed-compliant FFI (other than a registered deemed-complaint Model 1 IGA FFI), an exempt beneficial owner, or an excepted NFFE (other than a WP or WT). The new requirements don't contemplate the fact that many of these partnership and trusts are not professionally managed and, as such, are likely to be Passive NFFEs for purposes of FATCA. Given the new limitation, such entities would not qualify for joint account rules under the terms of the new agreement. The vexing issue is that, while many jurisdictions are in the process of modifying their data privacy laws as they relate to U.S. account disclosure, it is not anticipated that the modifications will extend such that a QI could report specific information relating to non-U.S. residents to the IRS.
Thus, QIs that operate in these jurisdictions that maintain such accounts held by partnerships or flow through trusts that are Passive NFFEs where the underlying owners are clearly documented to the QI as non-U.S. persons are now in a position where they are unable to comply with the reporting requirements of the new QI Agreement. Specific to this, it is important to note that the joint account provisions set forth in the prior QI Agreement had been the result of extensive negotiations between prospective QIs and the IRS in an effort to achieve a workable solution to those subject to local law reporting restrictions.
Finally, it is important to note that the new QI Agreement stipulates that the agreement between the QI and the partnership or trust must provide that the partnership or trust must make records available to the QI or its auditor for purposes of the QI’s compliance requirements. While this was also a requirement under the old provisions, the new language also provides that this includes records relating to IRS inquiries regarding the QI’s compliance review. Because existing “joint account” agreements are not likely to have that language, it would appear that QIs using this relief currently will need to update all such agreements.
Due Diligence Requirements / Presumption Rules
As anticipated, the updated due diligence requirements include the new indicia set forth in the chapter 4, as well as the updated chapters 3 and 61, regulations. One modification to note is the new apparent “fatal flaw” when an account holder provides a permanent residence address that is subject to a hold mail instruction.
Specifically, the new rules will not permit a QI to treat such an account holder as a foreign person regardless of additional documentation that would support (or even definitively establish) the person’s non-U.S status. Because there are legitimate, non-tax, reasons for account holders to provide hold mail instructions, this new rule is likely to result in some alternative mailing options (e.g., transitioning these account holders to online banking to eliminate the need for a hold mail instruction or some type of “specialty” mailing service whereby the QI forwards the account holder mail at stated intervals or only when specifically instructed to do so).
The new QI Agreement also contains significantly more onerous presumption rules that the QI must adhere to when it does not have valid documentation for an account holder (or when the documentation it does have is not reliable). Specifically, the new rules require the QI to apply separate rules for certain withholdable payments and payments that are amounts subject to withholding under chapter 3 but are not withholdable payments (because, for example, the payments are made with respect to a grandfathered obligation). In addition, the presumption rules for payments of foreign source income, broker proceeds and other income that is not a withholdable payment or an amount subject to chapter 3 withholding have been significantly modified.
Under the old rules, when these payments were made outside the U.S. to an offshore account, the QI could presume the payee to be to an exempt recipient (and thus, no withholding or reporting was required).
Under the new rules, such payments to an individual with U.S. indicia are presumed made to a U.S. non-exempt recipient. Further, if such payments are made to an entity, the presumption rules now cross reference the various Treasury Regulations that must be followed instead of the prior simplified rule outlined above. Where those rules result in a presumption that the payee is a U.S. non-exempt recipient, Form 1099 reporting is required. Backup withholding is not required, however, where the payment is paid and received outside the United States with respect to an offshore obligation and the QI does not have actual knowledge that the payee is a U.S. person.
Requirements for Pooled Reporting
The QI’s pooled reporting requirements are also more complicated under the revised agreement. Under the prior agreement, the QI would pool report by income type, withholding rate, exemption code, and recipient code. Separate pools were required for payments to the QIs direct account holders and payments to the direct account holders of the QI’s PAI (if any). Further, because the pool for tax-exempts had a different recipient code, payments to such entities were also required to be reported in separate pools.
While the new rules continue to require the QI to separately report the pools allocable to the direct account holders of a PAI and tax exempts, as described above, they also require the QI to separately report the pools associated with any partnership or trust that is acting as the QI’s agent pursuant to section 4.06 (old section 4A.02). In addition, the new QI Agreement also requires the QI to pool report all amounts subject to chapter 4 paid to the direct account holders of the QI (also bifurcated by pools associated with the direct account holders of any PAI or partnership or trust operating under the agency rules). The chapter 4 pools include withholdable payments allocable to NPFFIs, U.S. payees that were reported on Form 8966, and recalcitrant account holders. In addition, the latter recalcitrant account holder pools must be separated into the five different classifications delineated in the chapter 4 regulations (e.g., those with U.S. indicia, those without U.S. indicia, dormant accounts, etc.).
The new Agreement departs, substantially, from the external audit requirements set forth in the prior Agreement. Modeled after the compliance requirements in the FFI Agreement, the new QI Agreement requires the QI to appoint a Responsible Officer, who is required to adopt and implement a compliance plan, oversee that plan, and certify to the IRS the level of compliance every third year. The compliance program must include written policies and procedures, training, sufficient systems and processes, monitoring of business changes, as well as a periodic review and certification.
The periodic review may be performed by the QI’s internal audit function or by an external auditor or attorney. It is important to note that the requisite review exceeds the Phase 1 steps set forth in Revenue Procedure 2002-55 and includes detailed requirements to review policies and procedures, training materials, as well as interviewing employees to ensure they are adequately carrying out the requirements of the Agreement. It also includes the actual testing of accounts (through sampling) to determine the QI’s compliance level relating to documentation, withholding, and reporting (including a sample relating to the QI’s compliance with its FATCA requirements).
The Responsible Officer must then certify that:
- the QI has established a compliance program that meets the stated requirements;
- a periodic review was conducted and, based on that review (and other steps taken, if necessary), the QI maintains effective internal controls relating to its obligations as a QI and FFI and
- based on the results of the review and other information known to the Responsible Officer, there are no material failures (or, if there are material failures, the Responsible Officer must make a qualified certification disclosing such failures and the actions that have been employed to remediate them and prevent their reoccurrence.
At the time of the certification, the QI will also be required to provide the IRS with factual information (i.e., numerical results) relating to accounts, withholdable payments, and amounts subject to chapter 3 withholding. The IRS will prescribe, in future guidance, the factual information that the QI will be required to report. Unlike the previous audit waivers options for QIs that do not exceed certain reportable amount thresholds, the Agreement does not limit or reduce the compliance and certification requirements for smaller QIs.
Modifications for QIs that are NFFEs
If an effort to streamline QI applications for NFFEs that are acting as QIs with respect to unrelated persons, the new QI Agreement contains the restriction that this type of QI may not rely on documentary evidence and, instead, must rely on IRS forms only for documentation purposes. Prior to this, such QIs were required to execute a rider, stating the same, with their QI Agreements. With respect to reporting, there appears to be an oversight in the new Agreement. Specifically, the new Agreement provides that an NFFE QI must file a Form 8966 to report information about each substantial U.S. owner of a direct account holder that is a Passive NFFE.
The provision fails to limit the requirement for situations where the QI makes a withholdable payment. Most QIs that are NFFEs do not make withholdable payments and, consequently, will not be obtaining certifications relating to the FATCA status of their payees. The IRS is aware of this oversight and, presumably, it will be rectified in future guidance.
Term of New QI Agreement
Finally, it is important to note that the new Agreement will be in effect through 2016, as opposed to the previous 6-year term. The limited validity period was intentional, to align the validity period of the new QI agreement with the FFI and Intergovernmental Agreements.
For Your Reference
Revenue Procedure 2014-39 can be accessed by clicking here (PDF, 375 KB)
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