The Foreign Account Tax Compliance Act (“FATCA”) was enacted into U.S. law in 2010. The purpose of the law is clear – to encourage increased tax compliance for U.S. persons (citizens, green card holders, and other resident aliens) holding undeclared offshore accounts. The law was designed to be phased in over a number of years with a key aspect of FATCA to take effect beginning July 1, 2014. On that date, U.S. financial institutions and other payors of passive income will be required to withhold 30% of such payments to recipient financial institutions that are not in compliance regardless of the intended recipient of the payments.
This heavy incentive for foreign financial institutions to comply means that the names of many U.S. taxpayers with accounts at such institutions are being transmitted to the Internal Revenue Service (“IRS”) currently, or will be in the near future. As a result, U.S. persons with previously undeclared offshore assets or income should seriously consider entering into IRS’s Offshore Voluntary Disclosure Program (“OVDP”), or otherwise taking steps to become compliant by amending previously filed U.S. tax returns. For such taxpayers, now is the time to become compliant on a voluntary basis to avoid future higher levels of interest and penalties that in some cases are confiscatory. If a taxpayer instead waits until the IRS or other taxing authority contacts them, the consequences are likely to be substantially more severe.
The FATCA withholding will apply to the most common types of income, including interest, dividends, rents and royalties and most other income payments. In addition, effective January 1, 2017, proceeds from sales of securities in U.S. based accounts and certain loan repayments from U.S. borrowers will also be subject to the 30% FATCA withholding rate on the gross proceeds, absent compliance.
The impact of FATCA for foreign financial institutions is that they must register with the IRS and comply with all FATCA reporting and certification rules. The rules require these companies to identify all of their customers who are U.S. persons, and report information regarding these individuals and legal entities to the IRS either directly or through their home country fiscal authorities.
The penalty for a foreign financial institution failing to comply with the FATCA rules is that all of the income payable from the U.S. to the foreign financial institution (even if the income is beneficially owned by a customer of the bank) will be subject to the 30% FATCA withholding. In addition, as of January 1, 2017, all payments of proceeds from within the United States of sales of securities that generate interest or dividends (including certain loan repayments) will be subject to the 30% FATCA withholding.
It is important to keep in mind that the definition of a foreign financial institution is very broad and designed to cover a wide range of companies, not just retail and investment banks. Besides banks, the definition of a FFI may include non-U.S. venture capital funds, private equity funds, and certain foreign trusts.
Despite objections, non-U.S. financial institutions and foreign governments are moving to comply with FATCA in order to avoid the onerous withholding on payments from within the United States. In order to encourage compliance with FATCA, the U.S. government is negotiating as many agreements as it can with foreign tax collection agencies. These intergovernmental agreements (“IGAs”) are designed to override secrecy laws and they require FATCA compliance by financial institutions located within the signatory country. It is the IRS’s position that these IGAs do not rise to the level of a treaty requiring U.S. Congressional approval so, unlike tax treaties, that can take years to be ratified, the IGAs take effect as soon as the foreign government’s approval process is complete.
There are three IGAs that are currently in force, one with Japan, one with Mexico and one with Germany. In addition, another 47 IGAs have been signed or substantively agreed and are awaiting domestic approval, including those with British Virgin Islands, Liechtenstein, Switzerland, Luxembourg, Gibraltar, Jersey, Guernsey, Isle of Man, Bermuda, and the Cayman Islands. Another 22 IGA’s are under negotiation, including those with Brazil, the Bahamas, Russia, Panama, Cyprus, Israel, Hong Kong, Seychelles, Singapore, and Curacao.
Even though an IGA might not yet be in force in a particular country, many retail and investment banks are now complying with FATCA in anticipation of ratification. There have been notices sent to U.S. customers from banks in countries such as Bermuda, Switzerland and Israel and many other countries indicating that these banks will begin reporting the U.S. person’s account information to the IRS.
As discussed in our prior article, Is this the End of Banking Secrecy, the goal of all of this is to prevent U.S. taxpayers from hiding money in offshore accounts for the purpose of U.S. tax evasion. While FATCA is clearly aimed at bad actors, the law casts a very wide net. For example, under FATCA, all U.S. persons with “financial assets” outside of the United States over a minimum threshold must annually report the details of their assets on Form 8938 which is required to be attached to income tax returns. Form 8938 in some cases duplicates information that is required to be reported on the Foreign Bank Account Report (“FBAR”) that must also be filed each year.
FATCA rules force previously noncompliant U.S. taxpayers to bring their offshore assets “out from the shadows”, by requiring their foreign financial institutions to report to the IRS (directly or through their home country fiscal authorities) regarding their U.S. customers. As indicated, many foreign financial institutions have already sent notices to their U.S. customers that they will commence reporting their information to the IRS. Those banks that are not already complying with FATCA are likely to start soon.
In conjunction with FATCA, the IRS is currently administering the OVDP for U.S. persons with previously undisclosed assets offshore. Sometimes informally referred to as “Amnesty”, the OVDP requires noncompliant taxpayers to file corrected income tax returns and foreign asset disclosure forms for the previous eight (8) years, and pay back taxes, interest, certain income tax penalties, plus an “offshore” penalty of 27.5% of the highest value of assets outside of the U.S. during the 8 year period (subject to reduction in certain instances). In exchange for the taxpayer voluntarily coming forward and agreeing to these terms, and for providing a significant volume of information regarding the non-U.S. assets held (designed in many cases to identify their professional advisors), the IRS agrees not to pursue criminal prosecution and any of the other penalties that are potentially applicable to undisclosed foreign assets including the onerous “willful failure to file and failure to pay” penalties. If the IRS has already contacted a noncompliant taxpayer, the contacted taxpayer will generally be ineligible to participate in the OVDP.
An example of an onerous willful failure penalty that may be avoided by entering the OVDP is the penalty for the willful failure to file the FBAR. For each undeclared offshore account, the U.S. person can be penalized up to 50% of the highest balance in the account for every year it is undeclared, without limit other than the six (6) year statute of limitations applicable to this penalty. If applied, this penalty alone can easily exceed the value of the undisclosed foreign account. Since the civil penalties are not limited to the value of the undisclosed accounts it is possible that the IRS could pursue any other assets of the taxpayer whether they are held in the United States or elsewhere in the world.
The FBAR and Form 8938 as discussed above are just two examples of the blizzard of forms that U.S. persons are required to file to report their offshore assets and income. Other examples include Form 5471 for controlled foreign corporations, Form 8621 for passive foreign investment companies, Form 8865 for controlled foreign partnerships, Form 8858 for foreign disregarded entities, and Forms 3520-A and 3520 for foreign trusts and gifts from foreign persons. The penalties for the failure to file each one of these forms are potentially significant.
Of course, U.S. persons living outside of the United States, or with non-U.S. assets or income, should not delay in confirming that they are in compliance with all U.S. international tax and disclosure rules.
As a result of FATCA, especially the key provisions that are taking effect this year, U.S. persons should assume that the IRS will eventually discover their previously undeclared offshore assets and income. Therefore, it is imperative that such persons contact an international tax professional to assist them with entry into the OVDP, or to otherwise come into U.S. tax compliance. Unless this is done before the taxpayer is contacted by the IRS, the likelihood of criminal prosecution or extremely onerous civil penalties will substantially increase.
Solomon Blum Heymann provides a full range of legal services for businesses and individuals, especially those with international investments and businesses, including in the areas of taxation, corporate law, securities, and estate planning. Our tax department has substantial experience in practice before the IRS and state tax authorities, including with FATCA, OVDP, and other provisions aimed at non-compliant taxpayers.
Cristina Salvador, William L. Blum and Robert A. Ladislaw, IPBA Journal, March 2012, Page 44.