The recently enacted Foreign Account Tax Compliance Act (FATCA) added a chapter to the Internal Revenue Code designed to prevent U.S. persons from using offshore accounts and investments to evade U.S. tax. Effective July 1, 2014, any person making a payment of U.S. source income to either a Foreign Financial Institution (FFI) or a Non-Financial Foreign Entity (NFFE) must consider whether it is subject to FATCA.
1. Do Your Withholding Processes
Comply with FATCA?
The recently enacted Foreign Account Tax Compliance Act (FATCA) added a chapter to the Internal Revenue Code
designed to prevent U.S. persons from using offshore accounts and investments to evade U.S. tax. Effective July 1, 2014, any person making a payment of U.S. source income to either a Foreign Financial Institution (FFI) or a Non-
Financial Foreign Entity (NFFE) must consider whether it is subject to FATCA. U.S. entities, both financial and non-financial, that make payments of U.S. source income to non-U.S. persons will
be affected. There is a potential 30% U.S. withholding tax imposed on U.S. source "withholdable payments" made
to a non-U.S. entity under FATCA. The U.S. payor will need to understand the entity classification of its non-U.S.
payees under FATCA and will be required to maintain documentation on these non-US persons. Since the new FATCA requirements did not replace the existing withholding rules on payments of certain U.S.
source income to non-U.S. persons, businesses are currently reviewing their processes to ensure proper compliance with the existing withholding rules as well as the new FATCA provisions. Entity Classification
The compliance requirements for FFIs are significant, so the first step in the process is to determine whether an entity is classified as an FFI or a NFFE. An FFI is a foreign entity that meets one of the following criteria: 1. Accepts deposits in the ordinary course of a banking or other financial business;
2. Holds, as a substantial part of its business, financial assets on behalf of others;
3. Is engaged in the business of trading, investing or managing financial assets (e.g., securities, commodities,
partnership interests, and notional principal contracts) on behalf of customers;
4. Is a holding company or treasury center formed in connection with or availed by an investment vehicle, such as a
hedge fund or private equity fund; or
5. Is a foreign regulated insurance company that issues or makes payments with respect to cash value insurance
contracts or annuities.
2. A foreign entity that does not meet any of the foregoing criteria for treatment as an FFI is classified as an NFFE. Thus, for example, a non-U.S. holding company with subsidiaries engaged in a non-financial business is generally treated as an NFFE. Also, a foreign insurance company that sells insurance products without a cash value is not an FFI but instead is classified as an NFFE. In addition, the FATCA regulations specifically exclude certain non-U.S.
entities from FFI status, including certain start-up companies formed with the intention of operating a non-financial
business, non-financial entities in liquidation or bankruptcy, and treasury centers that are part of a non-financial
group. Once the classification of the non-U.S. entity is determined under FATCA, a payment made to that entity should be
reviewed to determine whether it is a payment of U.S. source income, and if so, the type of income. Income Classification
If a non-U.S. entity does not comply with the provisions of FATCA, a U.S. payor is required to withhold 30% on any U.S. source "withholdable payment" to that entity. A withholdable payment is generally defined to include: 1. Any payment of U.S. source interest, dividends, rents, royalties, salaries, wages, annuities, or other fixed,
determinable, annual or periodic income (FDAP);
2. Any gross proceeds from the sale or disposition of U.S. property that can produce interest or dividends; or
3. Interest paid by a foreign branch of a U.S. bank.
A payment of U.S. effectively connected income is not treated as a withholdable payment (and therefore is exempt
from FATCA withholding). Non-Financial Foreign Entities (NFFE)
Most non-U.S. operating businesses will be classified as NFFEs. Although FATCA is primarily focused on curbing perceived tax evasion by U.S. persons holding accounts or investments in foreign banks and other FFIs, it is also aimed at U.S. persons holding interests in NFFEs whose principal assets generate passive income and therefore
present a higher risk of tax evasion. FATCA addresses this second objective by requiring NFFEs to disclose their substantial U.S. owners (i.e., persons owning more than a 10% interest in the entity). Thus, unless a payee exception applies, an NFFE receiving a U.S. source withholdable payment must attest to certain information regarding its FATCA classification under penalties of perjury on a completed Form W-8BEN-E provided to the U.S. payor. The
30% FATCA withholding tax will apply to any NFFE failing to provide this information. FATCA withholding, however, is not required with respect to withholdable payments made to "excepted NFFEs" that are considered a low risk for tax evasion. An "excepted NFFE" includes the following foreign entities: 1. Publicly traded corporations and certain non-financial affiliates;
2. Non-financial holding companies;
3. Intercompany treasury and hedging centers that are part of a non-financial group; and
4. NFFEs in which less than 50% of their gross income is passive income and less than 50% of their assets are held
for the production of passive income (i.e., "Active NFFEs").
3. Certain other exceptions apply to withholding under the FATCA rules, including payments made in the ordinary course of the U.S. payor's business for non-financial services, goods, and use of property. This also includes interest
on outstanding accounts payable arising from the acquisition of non-financial services, goods and use of property. In addition, debt obligations outstanding on January 1, 2014 and certain other "grandfathered obligations" are also exempt from FATCA, unless material modifications are subsequently made to the loan. Practically, the U.S. withholding agent's reliance on the exceptions to FATCA withholding will vary. From the
withholding agent's perspective, collecting all W-8BEN-E forms may prove easier than determining various exemptions. FATCA and the Existing Withholding Requirements
Although both FATCA and the existing U.S. withholding tax rules levy a 30% withholding tax on payments to non-
U.S. persons, FATCA withholding applies to a broader range of income than the existing regime and applies regardless of statutory or tax treaty exemptions or reductions. As a result, the existing withholding processes and procedures you may currently have in place can act as a starting point, but changes will be required to comply with the FATCA provisions. Existing withholding rules and FATCA have different objectives, encompass a different
range of payments and require different information from foreign payees. FATCA withholding starts with U.S.
source "fixed or determinable annual or periodical" income ("FDAP") (which is where the existing withholding rules end), but generally extends to gross proceeds, and does not include the existing withholding rules' exceptions for ordinary course of business income and grandfathered interest payments. A few examples illustrate the differences between FATCA and the existing withholding rules.
1. U.S. source interest may not be subject to the existing withholding rules by reason of a treaty exemption,
however, it may be subject to FATCA withholding;
2. U.S. source services are subject to the existing withholding rules but not FATCA withholding if classified as
ordinary course of business income;
3. Gross proceeds are subject to FATCA, but are not subject to the existing withholding rules.
Furthermore, payments that are exempt from the existing withholding tax may become subject to FATCA withholding. For example, interest payments on a grandfathered obligation may ultimately be subject to FATCA if there is a material modification to the loan. Prior W-8BEN forms currently held by withholding agents only provide the information necessary under the
existing withholding rules and are insufficient for meeting the FATCA requirements. If a prior W-8BEN is relied upon, additional information will be required to supplement the outdated form. Many payors will request a W-
8BEN-E to ensure compliance with both the existing withholding rules and FATCA. The IRS has released revisions to other forms such as the Form W-9 and Form 1042, for example, in order to comply with the FATCA requirements.