Recent efforts of the U.S. government to recapture tax dollars hidden in offshore investment accounts have captured the full attention of leading banks and investment firms overseas.U.S. investment firms, however, have no reason to relax. More than ever before, U.S. mutual funds and other providers of U.S.-based investment offerings will be charged with policing these new efforts to compel proper reporting of U.S. taxpayer income.

The Foreign Account Tax Compliance Act (FATCA), which took effect on July 1, imposes an array of new compliance obligations on U.S. mutual funds. Signed into law on March 18, 2010, as part of the Hiring Incentives to Restore Employment Act (the HIRE Act), FATCA's primary goal is to combat tax evasion by U.S. taxpayers who fail to report income from overseas investments.To this end, FATCA imposes stringent due diligence, reporting and withholding obligations on foreign financial institutions (FFIs). Certain other non-U.S. entities that derive largely passive, investment type income (passive non-financial foreign entities or passive NFFEs) must disclose direct or indirect "substantial U.S. owners." Enforcement of this new tax compliance regime, however, falls primarily upon U.S. mutual funds and other providers of U.S. investment products.

FATCA MECHANICS

Although intended to raise revenue primarily through increased reporting of income from U.S. owned foreign investment accounts, FATCA enforces compliance by imposing a new 30% withholding tax, generally effective July 1, on payments of certain U.S. source income and (beginning in 2017) gross proceeds (withholdable payments) made to FFIs and passive NFFEs that are not FATCA compliant. The burden of this withholding falls heavily on U.S. mutual funds and other U.S. payors of withholdable payments. To satisfy this compliance burden, U.S. mutual funds (or, more specifically, their transfer agents) must have new systems in place to allow for proper (i) identification of shareholder account holders to determine their FATCA status, (ii) withholding from withholdable payments made to FFIs and passive NFFEs that are not FATCA compliant, and (iii) reporting of substantial U.S. owner information obtained from passive NFFEs. These new due diligence, withholding and reporting obligations augment the U.S. tax compliance burdens already imposed on U.S. mutual funds under existing information reporting, backup withholding and nonresident withholding tax regimes.

SHAREHOLDER ACCOUNT DUE DILIGENCE

To determine when FATCA withholding or reporting may be required, U.S. mutual funds must adopt account opening procedures that identify accounts held by non-U.S. entities.Non U.S. entity account holders must be further examined to determine whether they are FFIs or passive NFFEs. Upon identification of an FFI account holder, its FATCA status must be determined. Substantial U.S. owner information, or certifications as to the absence of such owners, must be obtained from passive NFFE account holders.

To facilitate the FATCA due diligence burden, the U.S. Internal Revenue Service recently revised IRS Forms W 9 and W 8, and released new IRS Form W 8BEN E. Non-U.S. entities generally will use the new IRS Form W-8BEN E to provide FATCA related certifications, as well as certifications previously provided on the pre-FATCA IRS Form W8 BEN (for example, in relation to nonresident withholding and backup withholding).FATCA compliant FFIs generally must also furnish a Global Intermediary Identification Number (GIIN) obtained from the IRS as part of their FATCA compliance process.

If, pursuant to the due diligence process, a U.S. mutual fund shareholder account is identified as that of an FFI or passive NFFE that is not FATCA compliant, the account must be coded for FATCA withholding.Unlike nonresident withholding, FATCA withholding must be applied at the full 30% statutory rate; no reduction is allowed (for example, for treaty eligible account holders or recipients of portfolio interest).In the case of a U.S. mutual fund, withholdable payments include ordinary dividend distributions and (beginning in 2017) redemption proceeds and (to the extent attributable to the disposition of securities that produce U.S. source dividends or interest) long term capital gain dividends. As with nonresident withholding, failure to withhold as required will subject a U.S. mutual fund or other U.S. withholding agent to liability for the underwithheld tax, as well as potential interest and penalties.

SUBSTANCIAL U.S. OWNER REPORTING

FATCA also expands the U.S. tax information reporting obligations imposed on U.S. mutual funds. Whereas, prior to FATCA, U.S. mutual funds generally were relieved of U.S. tax information reporting obligations (e.g., IRS Form 1099 reporting) in respect of non U.S. shareholder accounts, FATCA now requires U.S. mutual funds and other U.S. withholding agents to report substantial U.S. owner information obtained from passive NFFE shareholder accounts.For this purpose, the IRS recently released new IRS Form 8966. FATCA greatly increases the U.S. tax compliance burden for U.S. mutual funds that accept non U.S. entity investors.

FFIs and passive NFFEs, on the other hand, face an increased U.S. tax compliance burden by accepting reportable U.S. account holders (in the case of FFIs) or having substantial U.S. owners (in the case of passive NFFEs). U.S. mutual funds seeking to minimize their compliance burden may opt to exclude non-U.S. shareholders (or, at a minimum, non-U.S. entity investors).Non U.S. investment funds and other non U.S. financial entities may seek to prohibit U.S. taxpayers (including U.S. citizens living abroad) from opening or maintaining accounts. Furthermore, the heightened due diligence that FATCA requires of both U.S. and non-U.S. financial entities may have a rippling effect, causing both sets of entities to comply more vigilantly with applicable securities law offering restrictions (which may look to an offeree's place of residence). As a result, one can reasonably predict that, in addition to combating U.S. tax evasion, FATCA may have the unintended consequence of impeding cross border investment.

Adrienne M. Baker is a partner at Dechert, an international law firm.

 

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