In the wake of a series of scandals involving U.S. taxpayers sheltering their assets from the reach of the U.S. Internal Revenue Service (IRS), Congress enacted the Foreign Account Tax Compliance Act (FATCA) on 18 March 2010 as part of the Hiring Incentives to Restore Employment (HIRE) Act. The requirements imposed by FATCA were sweeping, and the financial world waited for the U.S. Treasury to issue guidance. After a series of notices, on 8 February 2012, Treasury finally issued its proposed FATCA regulations. After allowing for almost a year of practitioner review and commentary, Treasury issued final FATCA regulations on 17 January 2013.
FATCA categorizes non-U.S. entities as either foreign financial institutions (FFIs) or non-financial foreign entities (NFFEs). Generally, if a non-U.S. entity is not an FFI, it is categorized as an NFFE. FFIs are entities that fall within the following groups:
- Depository institutions that accept deposits in the ordinary course of a banking or similar business;
- Custodial institutions that hold, as a substantial portion of their business, financial assets for the benefit of one or more other persons;
- Investment entities that trade and manage financial assets on behalf of customers;
- Insurance companies that issue or are obligated to make payments with respect to a cash value insurance or annuity contract.
FATCA offers FFIs a choice: (1) enter into an FFI agreement with the IRS and comply with U.S. style reporting requirements or (2) subject payments of specified types of (primarily) U.S.-source income made to the FFI to a thirty percent (30%) withholding tax.
Those FFIs that enter into an FFI agreement (participating FFIs) agree to comply with a myriad of requirements including performing due diligence to identify any accounts they maintain for U.S. persons, reporting specified information on U.S. account holders acquired in this due diligence process, closing the accounts of “recalcitrant account holders”, and withholding on specified types of “passthru payments”.
The regulations allow certain specified FFIs (deemed compliant FFIs and exempt FFIs) to avoid withholding without entering into an FFI agreement. Exempt FFIs include, among others, specified foreign governments, central banks, and retirement funds. Deemed compliant FFIs are low risk FFIs that include registered deemed compliant FFIs, which must register with the IRS, certified deemed compliant FFIs, which are not required to register with the IRS but must provide withholding agents with specified documentation, and owner documented FFIs.
- An owner documented FFI is an FFI that meets certain specified requirements, including:
- The FFI must be an FFI solely because it is an investment entity;
- Generally, the FFI’s withholding agent must be a U.S. financial institution or participating FFI;
- The withholding agent must agree to satisfy the FFI’s reporting requirements with respect to any specified U.S. persons who hold an interest in the FFI;
- The FFI must provide its withholding agent with certain specified information, including:
- A withholding certificate identifying the FFI as an owner-documented FFI that is not acting as an intermediary;
- Either (1) an owner reporting statement and valid documentation with respect to each person identified as an owner or (2) a letter (“Substitute Letter”) from an attorney or auditor that is licensed in the U.S. or whose firm has a location in the U.S., signed no more than four years prior to the date of the payment, that verifies that the FFI is in compliance with the owner-documented FFI requirements and that certifies that the attorney or auditor has reviewed the FFI’s documentation with respect to all of its owners and debt holders. Note that if the FFI opts to provide a Substitute Letter, it must still provide an FFI owner reporting statement and a Form W-9 with any applicable waiver for each specified U.S. person that owns a direct or indirect interest in, or specified debt interest in, the FFI; and
- Any details relating to a change in circumstances.
Note that owner reporting statements contain details relating to the FFI’s interest holders including the name, address and taxpayer identification number of every individual and specified U.S. person who owns a direct or indirect equity interest in the FFI. For instance, a non-U.S. trust that qualifies as an FFI would need to disclose information regarding not only its U.S. beneficiaries (if any) but also its non-U.S. beneficiaries. Obviously, this raises substantial privacy concerns. Therefore, those FFIs that are eligible to claim owner-documented status should consider obtaining a Substitute Letter to protect the privacy of their non-U.S. interest holders. If the FFI does choose to obtain a Substitute Letter, the FFI should consider the fact that engaging an attorney (as opposed to an accountant/auditor) will allow the FFI to claim legal privilege in relation to information shared with that attorney so that any sensitive information disclosure can be appropriately managed. Such privilege could become important in protecting the FFI if, for instance, the FFI’s due diligence procedures uncover one or more “rogue employees” who have engaged in questionable activities. If the FFI chooses instead to engage an accountant that is not an attorney, the communications between the FFI and the accountant will not be protected by legal privilege and may therefore be discoverable.
NFFEs are subject to a much less onerous reporting and withholding regime. Like FFIs, NFFEs must report specified information to avoid thirty percent (30%) withholding. However, unlike FFIs, NFFEs are not required to enter into an agreement with the IRS to avoid withholding, but are simply required to provide the withholding agent with specified information pertaining to any “substantial U.S. owners” or to certify that they do not have any substantial U.S. owners.
What about Trusts?
The proposed regulations and notices did little to address the treatment of trusts and trust companies. The final regulations provide clarity in some areas while leaving others open to speculation.
The final regulations define “financial institution” to include depository institutions that accept deposits in the ordinary course of a banking or similar business. Banking or similar business is defined to include providing fiduciary services to customers. Therefore, under the final regulations, it appears that the IRS will treat non-U.S. trust companies as FFIs. As such, every non-U.S. trust company must decide whether it intends to enter into an FFI agreement or subject a portion of its income to a thirty percent (30%) withholding tax.
Grantor Trusts and Estates
Under the FFI regime, an FFI that has entered into an FFI agreement is obligated to report information regarding its U.S. accounts. A U.S. account is any financial account maintained by an FFI that is held by one or more specified U.S. persons or U.S. owned foreign entities. The general rule for trusts is that the trust is the account holder. However, if the trust is a grantor trust, the trust is not treated as the account holder. Instead, the “owner” of the grantor trust is treated as the account holder. Under the grantor trust rules, the owner is typically the individual who funds the trust. Therefore, an account held by a grantor trust with a non-U.S. owner should not be categorized as a U.S. account. As such, an FFI that holds an account of a non-U.S. grantor trust with a non-U.S. grantor should not be required to report the account even if there are U.S. person beneficiaries.
The final regulations also provide that accounts held by estates are excepted from the definition of a financial account.
Non-grantor Trusts: FFIs or NFFEs?
The proposed regulations left unresolved whether non-grantor trusts would be treated as FFIs or NFFEs. While the final regulations do attempt to resolve this issue, they still leave many questions unanswered. Under the final regulations, FFIs are any non-U.S. entities that fall into the categories of depository institutions, custodial institutions, investment entities, or insurance companies.
A custodial institution is an entity that holds, as a substantial portion of its business, financial assets for the benefit of one or more other persons. An entity is deemed to hold financial assets for the benefit of others as a substantial portion of its business if the entity’s gross income attributable to holding financial assets and related financial services equals or exceeds twenty percent (20%) of the entity’s gross income during the prior three years. Income attributable to holding financial assets and related financial services includes, but is not limited to, income generated from custody, account maintenance, and transfer fees. Therefore, it seems that the IRS could categorize a trust as an FFI under the FFI custodial institution category. However, the IRS does not address this issue. Instead, the IRS implies in the preamble to the final regulations that trusts will fall into the “investment entity” category.
An investment entity is defined broadly, but includes any entity that primarily conducts any of the following activities as a business on behalf of a customer: trading in certain financial instruments; individual or collective portfolio management; or otherwise investing, administering, or managing funds, money or financial assets on behalf of other persons. An investment entity also includes any entity whose gross income is primarily attributable to investing, reinvesting, or trading in financial assets if the entity is managed by another FFI. An entity is managed by another FFI if the managing FFI performs, either directly or through another third-party service provider, any of the activities described above on behalf of the managed entity. An entity is treated as primarily conducting as a business one or more of the activities described above if the entity’s gross income attributable to such activity or activities equals or exceeds fifty percent (50%) of the entity’s gross income during the three year period ending on 31 December of the preceding year. The final regulations provide the following examples for clarification:
- Example 5. Trust managed by an individual. On January 1, 2013, X, an individual, establishes Trust A, a non-grantor foreign trust for the benefit of X’s children, Y and Z. X appoints Trustee A, an individual, to act as the trustee of Trust A. Trust A’s assets consists solely of financial assets. Pursuant to the terms of the trust instrument, Trustee A manages and administers the assets of the trust. Trustee A does not hire any entity as a third-party service provider to perform [financial instrument trading; individual or collective portfolio management; or investing, administering, or managing funds, money or financial assets]. Trust A is not an investment entity…because it is managed solely by Trustee A, an individual.
- Example 6. Trust managed by a trust company. The facts are the same as in Example 5, except that X hires Trust Company, an FFI, to act as trustee on behalf of Trust A. As trustee, Trust Company manages and administers the assets of Trust A in accordance with the terms of the trust instrument for the benefit of Y and Z. Because Trust A is managed by an FFI, Trust A is an investment entity [by virtue of being managed by another entity that provides at least one of the following services: trading in certain financial instruments; individual or collective portfolio management; or otherwise investing, administering, or managing funds, money or financial assets on behalf of other persons] and an FFI.
The examples make it clear that if a trustee or grantor does not engage a third-party FFI to manage any aspect of the trust, the trust should not be an FFI under the investment entity definition. Additionally, if a grantor or trustee engages a trust company as trustee, the examples make it clear that the trust will be treated as an FFI. The final regulations also imply that if an individual trustee manages the daily aspects of the trust, but the trustee or grantor engages an FFI to manage the trust’s portfolio, the IRS would treat the trust as an FFI under the investment entity category. Under this analysis, any trust with a professionally managed portfolio (ie, almost any sizeable trust) will be treated as an investment entity and, as such, an FFI subject to reporting and withholding requirements in its own right.
Despite treatment as FFIs, many trusts should be eligible to claim owner-documented FFI status. As noted above, this would allow eligible trusts to protect the privacy of non-U.S. beneficiaries through the Substitute Letter mechanism and to avoid withholding without entering into an FFI agreement.
A trust categorized as an FFI that opts to forgo owner-documented FFI status must enter into a formal FFI agreement obligating the trust to perform the due diligence required to identify and report information about its beneficiaries, including “substantial U.S. owners.” For investment entities, including trusts that so qualify, a substantial U.S. owner means a U.S. beneficiary with any interest whatsoever. Therefore, generally, a trust treated as an FFI will be required to report specified information to the IRS regarding all of its U.S. beneficiaries. However, the regulations provide a de minimis exception that states that a U.S. person is not treated as a substantial U.S. owner if the fair market value of the distributions to that person during the calendar year are US$5,000 or less and, in the case of a person entitled to mandatory distributions, the value of that person’s interest in the trust is US$50,000 or less.
A trust treated as an NFFE is subject to relaxed reporting requirements, and must simply provide the withholding agent with specified information pertaining to any “substantial U.S. owners” or certify that it does not have any substantial U.S. owners. For purposes of a trust classified as an NFFE, a substantial U.S. owner is any specified U.S. person that holds, directly or indirectly, more than ten percent (10%) of the beneficial interests of the trust. An individual holds a beneficial interest if he or she has the right to receive, directly or indirectly, a mandatory distribution or he or she may receive, directly or indirectly, a discretionary distribution from the trust. Importantly, a person’s proportionate interest in a non-U.S. trust is aggregated with related persons who also hold beneficial interests in the trust. Generally, a person is treated as holding more than ten percent (10%) of the beneficial interest of a trust if:
- The beneficiary receives only discretionary distributions from the trust and the fair market value of the distributions from the trust to such person during the prior calendar year exceeds ten percent (10%) of the value of either all of the distributions made by the trust during that year or all of the assets held by the trust at the end of that year;
- The person is entitled to receive mandatory distributions from the trust and the value of the person’s present interest in the trust exceeds ten percent (10%) of the value of all the assets held by the trust; or
- The person is entitled to receive mandatory distributions and may receive discretionary distributions from the trust and the value of the person’s interest in the trust, determined as the sum of the fair market value of all of the discretionary distributions made from the trust during the prior calendar year to the person and the value of the person’s present interest in the trust at the end of that year, exceeds either ten percent (10%) of the value of all distributions made by the trust during the prior calendar year or ten percent (10%) of the value of all the assets held by the trust at the end of that year.
The regulations provide the following example:
- Example 3. Determining the 10% threshold in the case of a beneficial interest in a foreign trust. U, a U.S. citizen, holds an interest in FT1, a foreign trust, under which U may receive discretionary distributions from FT1. U also holds an interest in FT2, a foreign trust, and FT2, in turn, holds an interest in FT1 under which FT2 may receive discretionary distributions from FT1. U receives $25,000 from FT1 in Year 1. FT2 receives $120,000 in year 1 and distributes the entire amount to its beneficiaries in Year 1. The distribution from FT1 is FT2’s only source of income and FT2’s distributions in Year 1 total $120,000. U receives $40,000 from FT2 in Year 1. FT1’s distributions in Year 1 total $750,000. U’s discretionary interest in FT1 is valued at $65,000 at the end of Year 1 and therefore does not meet the 10% threshold… U’s discretionary interest in FT2, however is valued at $40,000 at the end of Year 1 and therefore meets the 10% threshold.
Note that the regulations provide a de minimis exception allowing a beneficiary to avoid substantial U.S. owner treatment if the fair market value of the distributions from the trust to such person during the prior calendar year were US$5,000 or less and, in the case of a person entitled to mandatory distributions, the value of such person’s interest in the trust is US$50,000 or less.
As an alternative to the withholding and reporting regime required under FATCA, several countries have entered into inter-governmental agreements (IGAs) with the U.S. Under the Model 1 IGA, FFIs can report FATCA-like information directly to the revenue agencies of their home countries. These revenue agencies will then share information regarding U.S. account holders directly with the IRS.
There are two versions of the Model 1 IGA: reciprocal and nonreciprocal. Under the reciprocal version IGA, the U.S. agrees to share information collected in the U.S. on non-U.S. account holders with the other country. Under the nonreciprocal version IGA, the U.S. does not agree to share information. In order for the U.S. to enter into a reciprocal version IGA, the non-U.S. country must have in place “protections and practices” that are determined by the U.S. Treasury and the IRS to be adequate to ensure that the exchanged information remains confidential and is used solely for tax purposes. It remains unclear by what criteria the U.S. Treasury and the IRS will actually judge which countries’ “protections and practices” meet this standard.
Under the Model 2 IGA, FFIs request permission from account holders to share information with the IRS. If account holders refuse to consent, FFIs can report information relating to all of their non- consenting account holders in the aggregate to the IRS. If the IRS requests additional information from a particular FFI, the FFI would report that information to its home country revenue agency that would then provide it to the IRS. FFIs in jurisdictions that have signed Model 1 IGAs should comply with the IGA in effect in their jurisdictions. Note, however, that in certain instances Model 1 IGAs give FFIs the option to comply with the requirements set forth in the regulations as opposed to the IGA.
FFIs in jurisdictions that sign Model 2 IGAs will be expected to comply with the regulations except to the extent provided in their IGAs. At the time of the writing of this article, the U.S. Treasury Department reports that the United Kingdom, Denmark, Mexico and Ireland have entered into IGAs with the U.S.
The final FATCA regulations contain a number of implementation timelines and phase-ins. Below are a few of the most significant.
- 15 July 2013: The IRS portal whereby FFIs can enter into FFI agreements will be open.
- 25 October 2013: Final day an FFI can enter into an FFI agreement that will ensure that the FFI is included on a list of participating FFIs published by the IRS prior to the commencement of FATCA withholding.
- 1 January 2014: Withholding begins. All accounts maintained prior to this date are pre-existing accounts.
- 31 March 2015: Due date for the first information reports with respect to the 2013 and 2014 calendar years.
- 31 December 2015: Deadline to document account holders and payees that are not prima facie FFIs.
- 1 January 2017: Withholding begins on gross proceeds from sales or dispositions of property and on foreign passthru payments.
The final regulations provide much needed guidance concerning the implementation of FATCA. In relation to trusts in particular, it seems clear that non-grantor trusts should be tested for FFI status under the “investment entity” category pending further guidance. Unfortunately, the final regulations also leave uncertainty surrounding the application of FATCA to many non-U.S. trusts by only providing two examples that address vastly different scenarios. The gulf between these two examples leaves room for differing interpretations of whether trusts that are not addressed specifically in the examples qualify as FFIs. Nevertheless, prudence would dictate that unless a trust with U.S. investments has no third-party professional involvement or holds relatively few financial assets, it should prepare to either (1) enter into an FFI agreement and comply with detailed IRS reporting and due diligence requirements or (2) obtain owner-documented FFI status, preferably with a Substitute Letter to protect the privacy of its non-U.S. beneficiaries. In either case, life is soon to become significantly more complicated for the trustees and beneficiaries of these non-US trusts.
 A trust holding only real estate, art or other non-financial tangible assets should not qualify as an “investment entity”. Therefore, assuming (as implied by the preamble to the final regulations) that a trust would only qualify as an FFI under the “investment entity” category, such a trust should be treated as an NFFE pending further guidance.  Owner documented FFI status is available only to those entities that are FFIs solely under the investment entity category.  FFIs must report all U.S. accounts, which include both accounts held by U.S. persons and accounts held by U.S. owned foreign entities. A U.S. owned foreign entity includes any non-U.S. entity that has one or more substantial U.S. owners. For trusts that fall within the investment entity category, a “substantial U.S. owner” includes any specified U.S. person that holds, directly or indirectly, more than zero percent (0%) of the beneficial interest of the trust. A person has a beneficial interest in a non-U.S. trust if that person has the right to receive directly or indirectly a mandatory distribution from the trust or if that person may receive discretionary distributions from the trust.  IGAs between the U.S. and Spain, Japan, Switzerland, and Norway are reportedly in late stage negotiations.  The final regulations reserved on the definition of “pass thru payments”, but it is possible that such payments could include payments arising from non-US sources as specified in prior IRS guidance. If pass thru payments ultimately include non-US source income, then limiting the trust’s portfolio to non-US investments may not solve the trust’s FATCA withholding tax problem.