Foreign Account Tax Comliance

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July 2010

Taxes—The Tax Magazine®©2010 D. Marsan

Dean Marsan was a first a Vice President and a Senior Tax Counsel with Lehman Brothers Inc. in New York City for the past 20 years. He was a participant on the American Bar Association Tax Section ad hoc committee for the “Comments on H.R. 3933 (H.R 3933, S. 1934) Foreign Account Tax Compliance Act of 2009 (FATCA),” which was submitted by the American Bar Association Tax Section on December 3, 2009, to the U.S. Senate Finance Committee and the House Ways and Means Committee. Most recently he was a participant on the ABA Tax Section FATCA and 871(l) comment committees and the New York State Bar Association Tax Section ad hoc committee for its report on FACTCA. He can be reached at [email protected].

FATCA: The Global Financial System Must Now Implement a New U.S. Reporting and Withholding System for Foreign Account Tax Compliance, Which Will Create Significant New Exposures—Managing This Risk (Part I)

By Dean Marsan

This article will be a separated into a three-part series that will appear in the July, August and September editions of TAXES—The Tax Maga-

zine. The article will address the new reporting and withholding regime imposed upon foreign financial institutions and nonfinancial foreign entities, its im-pact on banks, insurance companies, multinational corporations and investment and mutual funds, as well the new reporting requirements for uncertain tax positions for U.S. and foreign corporations including life, property and casualty insurance companies and new tax compliance for individuals with foreign as-sets. In addition, the article will discuss changes to the tax treatment of substitute dividends and dividend equivalent payments received by foreign persons, the repeal of certain foreign exceptions to the registered

bond provisions, IRS U.S. withholding tax and in-formation reporting examinations, liabilities for U.S. withholding tax, interest and penalties, U.S. account exposures, prophylactic planning and action steps, corporate governance and compliance to manage the U.S. account risk.

Part I discusses the purposes, goals, legislative history and mechanics of FATCA, tax and securities law exposures, proposed reporting requirements for uncertain tax positions, the impact of the law on umbrella structures and options for foreign en-tities, withholdable payments to foreign financial institutions, definition of withholding agent and with-holdable payment, the general requirements to avoid FATCA withholding, Coded Sec. 1471(b) agreement implementation (and termination) issues, gross-up provision concerns, waiver of foreign law, confidenti-ality, withholding on recalcitrant account holders and noncompliant FFIs and electing out using a hybrid FFI agreement, addressing failures to withhold FATCA taxes, issues on passthrough payments for foreign banks, insurance companies and multinationals and FATCA’s impact on an FFIs “expanded affiliated group,” due diligence and KYC requirements under FATCA, bypassing the Code Sec. 1471(b) agreement for FFIs with no U.S. accounts, the viability of the full 1099 reporting option, exceptions for certain payments, the FFI annual reporting requirement and FATCA’s impact on existing QIs.

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New U.S. Reporting and Withholding System for Foreign Account Tax Compliance (Part I)

I. IntroductionThe ProblemIt has been estimated that the United States loses an estimated $345 billion in tax revenues each year as a result of offshore tax abuses1 primarily from the use of concealed and undeclared accounts held by U.S. tax-payers or their controlled foreign entities. U.S. persons have a duty to report to the Treasury their worldwide income they earn through both domestic and foreign accounts. In order to eliminate the tax gap, it is not surprising that the government recently ratcheted up its pressure on taxpayers who structured their activities, in many cases, with the active help and assistance of promoters and facilitators to avoid reporting their tax-able income on their tax returns or hide these offshore accounts from the government.

Administration ResponseThe Obama Administration has actively pursued a “carrot and stick” strategy to remedy this tax gap by U.S. persons:

A voluntary disclosure program, which officially was available until October 15, 2009, but is still ongoing, permits a taxpayer with undisclosed offshore accounts to voluntarily disclose his ac-counts, become compliant and possibly mitigate substantial civil penalties and reduce the risk of criminal prosecution.The Treasury ramped up enforcement of cross-border withholding taxes, the U.S. Department of Justice increased civil and criminal prosecutions for tax fraud or evasion, and the IRS increased civil and criminal audit enforcement.

According to a recent press article,2 1.4 million Americans were audited last year—the most in a de-cade. More importantly, more audits are expected as the Administration plans to spend $8.2 billion in tax enforcement initiatives in 2011, a nearly 10-percent increase. Among its targets are not only U.S. persons residing in the United States, but also an estimated six million U.S. citizens who are living abroad, many of whom the IRS believes are not paying U.S. taxes based on their mistaken belief they are not subject to U.S. tax since they are already paying taxes abroad.3

In addition to issues related to tax evasion by U.S. citizens and residents, the Treasury has also targeted several industries as having exposure to the risk of cross-border withholding including financial ser-vices, technology, pharmaceutical and professional services, as well as businesses with a heavy focus

on intellectual property under the existing withhold-ing and reporting requirements of Chapter 3 of the Internal Revenue Code.

Congressional Response: FATCA Legislation Targeting Tax Evasion by U.S. Persons—Legislative History

In response to tax evasion by U.S. persons through the use of offshore accounts, and because of Con-gressional and Treasury dissatisfaction with the effectiveness of the know-your-customer and other customer identification practices and failure of the information reporting system in the UBS case and its progeny, Senators Baucus of Montana and Kerry of Massachusetts, together with Representatives Rangel of New York and Neal of Massachusetts, introduced the Foreign Account Tax Compliance Act (H.R. 3933; S.1934) (FATCA or “the Act”) on October 27, 2009. On December 7, 2009, Representative Charlie B. Rangel introduced the Tax Extenders Act of 2009 (H.R. 4213) (“Extenders Act”), which subsumed the proposed FATCA legislation and was passed by the U.S. House of Representatives on December 9, 2009, by a vote of 241-181.4

On February 1, 2010, the Obama Administration (“the Administration”) released the General Expla-nations of the Administration’s Revenue Proposals (commonly known as the “Green Book 2011 Pro-posal”). The Green Book 2011 Proposal includes the foreign account tax compliance proposals as part of its budget proposal, although the Administration did not release proposed statutory language. On February 11, 2009, the Senate Finance Committee released a bipartisan draft of the Hiring Incentives to Restore Employment Act (“HIRE Act”), which included the foreign account tax compliance provisions discussed in this article and which is substantially unchanged from the Extenders Act, with the exception of four changes noted below. On February 24, 2009, the Sen-ate passed 70-28 a stripped-down version of the HIRE Act (H.R. 2847), which included the foreign account tax compliance provisions substantially unchanged from what was included in the HIRE Act.

The revised HIRE Act was passed by the House on March 4, 2010, by a vote of 217-201 and passed in the Senate on March 17, 2010, by a vote of 68-29, and was signed into law by President Obama on March 18, 2010.

The HIRE Act (P.L. 111-47) includes many of the provisions that were in FATCA and includes a matrix

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of rules that (i) imposes a new punitive 30-percent withholding tax on payments of U.S.-source invest-ment income to enforce new reporting requirements on certain foreign accounts held by U.S. persons; (ii) imposes a withholding tax on “substitute dividend” and “dividend equivalent payments”; (iii) eliminates the withholding tax exemption for bearer bonds; (iv) provides for new income tax return reporting require-ments for “specified foreign financial assets”; (v) adds an annual information reporting requirement for pas-sive foreign investment companies (PFICs); (vi) imposes new information reporting penalties and also lengthens the statute of limitations to six years in the case of a significant omission of income in connection with certain foreign assets; (vi) extends the period during which the IRS does not have to pay interest on certain overpayments of tax; and (viii) imposes new rules for the treatment of foreign trusts.5 The HIRE Act foreign account compliance provisions will impact not only investors and foreign financial institutions but also investment and mutual funds, American expatriates and issuers of non–publicly traded debt and equity.

While the Hire Act also generally follows the pro-visions included in the Extenders Act, the successor legislative proposal to FATCA, it had several notable differences that give the Treasury more latitude in providing guidance to taxpayers to implement the new law.

More specifically, the HIRE ACT (i) narrows the definition of “foreign financial institution” by in-cluding “an entity that as a ‘substantial’ portion of its business, holds financial assets for the account of others,” which previously had read, “an entity engaged in the business of holding financial assets for the account of others”; (ii) give the Treasury the authority to except from the reporting requirement information with respect to each U.S. account relat-ing to the gross receipts and gross withdrawals or payments from the account; (iii) gives the Treasury the authority to modify the definition of “financial account”; and (iv) broadens the grandfather rule for the effective date of the new Chapter 4 withholding rules by providing that the new law will not require any amount to be withheld or deducted from any payment under any obligation outstanding on March 18, 2012, or “from the gross proceeds from any dis-position of such obligation.”

The new law will significantly change the U.S. withholding and information reporting rules for the global financial system for cross-border investments with U.S. customers and is generally effective for

payments made after the end of 2012. Some have nicknamed the new legislation the “FATCAT” legisla-tion based on its earlier acronym.

Some commentators have suggested that because the new law imposes obligations on many foreign parties, non-U.S. persons will likely weigh carefully their decision to do business in the United Sates or with U.S. persons. However, it is likely that foreign and commercial banks, foreign funds, brokers, clear-inghouses and other foreign financial institutions will enter into agreements with the Treasury to become foreign account compliant.

Recent Senate AML Probe into Foreign Persons Beneficial Ownership of U.S. Accounts

Since the enactment of the Patriot Act,6 many U.S. financial institutions have been required to imple-ment anti–money laundering (AML) programs, with written policies, procedures and controls, and including retaining an AML compliance officer, providing employee training and conducting in-ternal audits, unless explicitly exempted by the Treasury Secretary.7 It also required the institutions to obtain customer identification information for each account opened.8 Regulations issued by the Treasury over the next few years implemented the Patriot Act provisions, requiring U.S. banks, securi-ties firms, insurance companies, futures commission merchants, jewelry businesses and money service businesses, among others, to develop the specified AML programs. At the same time, however, the Treasury exempted several groups from having to establish AML programs, including hedge funds, the real estate industry and escrow agents.9

On February 4, 2010, Senator Carl Levin’s Perma-nent Subcommittee on Investigations released a 325 report (“the Senate Report”) entitled Keeping Foreign Corruption out of the United States: Four Case Histo-ries, and conducted hearings on funds transferred by foreign persons to U.S. accounts. The Senate Report details how U.S. banks helped facilitate the flow of “dirty money” into the United States by foreigners. The Senate Report asserted that banks ignored controls intended to prevent money laundering and related screens on politically exposed persons, or “PEP,” and recommended strengthening regulations against money laundering at the banks under the Patriot Act by requiring U.S. corporations to identify their foreign beneficial owners, in order to thwart the use of shell

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companies with hidden owners. More specifically, the Senate Report recommended persons forming U.S. corporations disclose the names of the beneficial owners of those corporations and that the Treasury repeal all of the exemptions it has granted from the Patriot Act requirement for AML programs.

It is too early to tell whether Congress or the Treasury will propose separate foreign investor legislation or regulations that will require BSA or Patriot reporting. Any new legislation will likely target information reporting for foreign investors with financial accounts in the United States and will presumably have as its objectives strengthening bank controls over foreign persons, including the following requirements for banks:

Use of reliable databases to screen potential foreign clientsPossible use of account forms that ask for ultimate beneficial ownership informationObtaining financial declaration forms filed by foreign clients at the time of account opening and for any beneficial ownership changes while the account remains openAnnual reviews of foreign account activity to de-tect and stop suspicious activity or transactions.

It remains to be seen what sanctions Congress or the Treasury might impose to ensure compliance if these proposals or similar proposals are forthcoming.

Global Financial System ExposuresThe new law will have a large impact not only on U.S. persons who are engaged in tax evasion and their promoters, but also on the global financial system including banks, financial service companies, asset managers and fund managers who will be responsible for satisfying the new law’s disclosure, reporting and withholding requirements. The new law generally as-sumes these institutions will devote sufficient resources, processes and people for flawless execution, and if they fail to do so, it is at their peril and liability.

While the new law generally does not create new civil or criminal penalties for violations, it does impose significant new disclosure, reporting and withholding responsibilities on foreign financial institutions to obtain information about each U.S. account, comply with verification and due diligence and compliance procedures (e.g., know-your-custom-er), provide disclosure to the IRS and, if necessary, withhold U.S. tax on these accounts.

If one of these companies, private bankers or busi-ness managers attempts to evade U.S. tax by avoiding

the new law’s disclosure and reporting and withhold-ing requirements by assisting or otherwise facilitating undeclared U.S. taxpayers and enabling them to con-ceal from the IRS the active trading or stocks, securities or other assets held in these accounts or the income from these assets, it is likely severe civil and criminal liabilities will be incurred by such institution.

Since the new law very likely “institutionalizes” the information diligence and reporting processes (as well as the internal and external audit and verification processes retained by such institution), presumably through the legal, compliance and tax departments of these companies with reporting lines directly to the General Counsel, Global Risk or Compliance Direc-tor, Global Tax Director or Committees reporting to the Board of Directors, the possible defense that such actions were an isolated occurrence by one business manager or unit and not known by the institution will no longer pass muster to avoid liability.

These new diligence and verification responsibili-ties will require a financial institution to identify the ultimate beneficial U.S. owners of its customers finan-cial accounts on a global basis and will require the institution to “look through” multiple tiers of entities which these customers or other promoters may have created to avoid their U.S. tax obligations unless the Treasury provides guidance otherwise.

Based upon the recent UBS case (see discussion below), an offending institution in an egregious case may be required by the federal government to (i) disgorge any profits from such evasion as a nondeductible penalty for the years in which the illegal activity was incurred, pay withholding taxes, interest and tax penalties; (ii) pay restitution for any unpaid taxes and interest that were incurred by these recalcitrant customers; (iii) exit profitable businesses or platforms from which the activities arose; (iv) provide disclosure of detailed client and account holder information to the government; (v) provide as part of the settlement public disclosure of the institution’s culpability for its conduct—at risk to its brand and reputation; (vi) revoke, terminate or suspend any licenses, approvals or authorizations, for example, as a broker dealer, investment advi-sor for banking, investment banking or investment activities in the United States; (vii) enter into a de-ferred prosecution agreement requiring substantial resources for compliance with its terms; and (viii) face possible indictment and conviction for willfully and knowingly conspiring to defraud the United States10 among other criminal statutes if the terms of


July 2010

deferred prosecution agreement are not satisfied in a manner acceptable to the government. As collateral exposure, the foreign financial institution may also be subject to both civil and criminal proceedings for tax evasion and for violation of business authoriza-tions, approvals and licenses to do business and for violation of other laws in other countries, as well as in the states where the institution does business.

Even in less egregious cases where no criminal misconduct is alleged, the financial institution may be subject to significant financial statement reserve exposure under FIN 48 or FAS 5, which may have to be disclosed on its audited financial statements and to the IRS (see “Proposed Reporting Requirements of Uncertain Tax Positions May Apply to New Withhold-ing Tax Regime in the Future”), as well as interest, civil tax penalties and securities law sanctions, creat-ing significant negative exposure for the firm.

Tax Penalty ExposureA withholding agent or payor under the new law will be personally liable to the government for a 30-percent withholding tax on “withholdable payments” made to foreign financial institutions or nonfinancial foreign entities if the information disclosure and other require-ments in the new reporting regime are not satisfied together with interest on the underwithheld tax. In addition, a withholding agent may be liable for the so-called 100-percent penalty equal to the amount of the tax evaded or not collected or not accounted for and paid over; the 40-percent accuracy-related penalty11 of the amount of the underpayment attributable to any “undisclosed foreign financial asset”; or 75 percent of the amount of the understatement of withheld tax in the case of civil fraud and even possible criminal penalties. It is also possible that a withholding agent may be liable to a payee for under withholding in a separate suit. In addition, it is likely that the foreign countries or states where a firm does business will also seek to impose liability on the firm for withholding or restitution taxes, interest and penalties if they believe their tax laws were violated. See “Liability for With-holding Tax, Interest and Penalties.”

Tax Penalties May Create Significant Exposure Exceeding the Amount in Account, Maybe Overly Broad, Applied Concurrently and Difficult to Abate

It is not an overstatement to say that these penalties can be overly broad and applied to sophisticated financial

institutions, investment and mutual funds and even to a small group of U.S. investors with offshore accounts, and may be difficult to abate (although these penalties will not currently be applied on a strict liability basis,12 and the defenses of “reasonable cause and good faith” may be available in a particular case). It should be noted these penalties may be stacked with economic consequences far exceeding the investment value of these accounts. In many cases, a foreign financial in-stitution may incur significant penalty exposure even if the mistakes in the reporting of the U.S. accounts may be attributable to inaccurate, incomplete or erroneous information about the beneficial owner of the account holder provided by a foreign custodian or other unre-lated foreign agent of the beneficial owner.

Securities Law Exposure—Violation of Sections 13 and 15a of the Exchange Act of 193413 and Violation of Section 203a of the Investment Advisors Act of 194014

A financial institution that solicits, establishes and maintains brokerage accounts for cross-border U.S. clients, provides account information, executes se-curities transactions and receives transaction-based compensation may be liable as an unregistered broker-dealer, requiring the financial institution to disgorge its profits and gains from such cross-border business. In addition, the Financial Industry Regulatory Authority (FINRA) may impose separate penalties, possible censorship and other sanctions for a financial institution’s failure to supervise and control its U.S. customers financial accounts by not having proper information reporting, verification, reporting and withholding systems and procedures that are fully compliant with the new law.

Proposed Reporting Requirements for Uncertain Tax Positions May Apply to New Withholding Tax Regime in the Future

Administrative history. Many taxpayers are currently required by FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48),15 to identify and quantify uncertain tax positions taken in their tax return for financial statement purposes. On January 27, 2010, the IRS in Announcement 2010-9 under the heading, “Uncertain Tax Positions—Policy of Restraint,” ratcheted up this disclosure requirement by proposing that a corporation and other business entities with total assets in excess of $10 million be required to provide

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to the IRS an annual schedule if the business entity had one or more uncertain tax positions on their tax returns and presumably including any uncertain tax position related to a business entity’s failure to withhold under Chapters 3 and 4 of the Code in the near future.

It seems clear that Congressional authority is not necessary for the IRS to implement the proposal and include taxpayers who prepare audited financial statements and are involved in the audited financial statements of a related entity that prepares financial statements and will likely be applied to 2010 tax re-turns and filed with the corporate tax return or other business returns.16 Presumably, this will include part-nership entities in the very near future. While the form is currently in development (a draft Schedule UTP was circulated in April 2010), it is expected to be finalized by the fourth quarter of 2010.17

On April 19, 2010, the IRS issued Announcement 2010-30, which provided additional detail regarding who must file the Schedule, the reporting requirements and what type of information a taxpayer will have to provide, and released a draft Schedule UTP which must be attached as part of a corporation’s income tax return, together with detailed draft instructions including examples (hereinafter collectively referred to as “Schedule UTP”). The IRS has asked for public comments about the new Schedule and instructions.

At a recent Tax Executive Institute seminar in New York City, when asked if regulations would be forth-coming in addition to these instructions, officials at the LMSB division of the IRS indicated no regulation project was currently planned for the area.

What will happen to the IRS “policy of restraint”? While the Treasury (but not foreign, or state and local taxing authorities) now intends to retain its existing policy of restraint with respect to tax accrual work-papers, it may consider additional modifications as appropriate or necessary to ensure it obtains complete and accurate information regarding a taxpayer’s “un-certain tax positions.” However, it should be noted the IRS does not contemplate taxpayers will claim privilege with respect to the requested disclosures.

Who must file the Schedule UTP? The instructions indicate that, beginning in 2010, corporations with uncertain tax positions and assets equal to or exceed-ing $10 million will be required to file Schedule UTP with the tax return if they or a related party issued audited financial statements. Under the instructions to the Schedule UTP, if a corporation (as identified below) (i) has assets equal or exceeding $10 million, (ii) has one or more tax positions that must be reported on

Schedule UTP, and (iii) has issued an audited financial statement that covers all or a portion of the corpora-tion’s operations for all or a portion of the corporation’s tax year, then they are required to file. These corpora-tions include U.S. corporations that are required to file an Form 1120 (U.S. Corporation Income Tax Return), insurance companies that are required to file a Form 1120L (U.S. Life Insurance Company Income Tax Return) or Form 1120PC (U.S. Property and Casualty Insurance Company Tax Return) and foreign corpora-tions that are required to file Form 1120F (U.S. Income Tax Return of a Foreign Corporation).

Consolidated Schedule UTP filing by affiliated group. An affiliated group of corporations filing a consolidated return will file Schedule UTP for the af-filiated group. The affiliated group need not identify the member of the group to which the tax position re-lates or which member recorded the reserve for the tax position. Any affiliate that files separately and satisfies the requirements for filing must file a Schedule UTP with its return setting forth its own tax positions.

Passthrough entities and partnerships. For 2010, the IRS will not require a Schedule UTP from other Form 1120 series filers (other than those identified above), such as real estate investment trusts, regulated invest-ment trusts or from passthrough entities or tax-exempt organizations, although they may have to file the Schedule in the future. The most recent announce-ment suggests the IRS will determine the timing for the requirement to file the Schedule UTP for these entities after comments have been received and considered.

What about duplicative reporting? The IRS is reviewing the extent to which the Schedule UTP duplicates other reporting requirements such as the Form 8275, Disclosure Statement, Form 8275-R, Regulation Disclosure Statement, Form 8886, Re-portable Transaction Disclosure Statement and the Schedule M-3, Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More. The instructions provide a taxpayer will be treated as having filed a Form 8275 or Form 8275-R for tax positions that are properly reported on Schedule UTP, and such returns need not be filed to avoid penalties with respect to that tax position.

What are the sanctions for failure to report uncertain tax positions? Announcement 2010-9 provided the IRS will be evaluating its options for penalties or sanctions for failure to make adequate disclosure of the required information regarding a taxpayer’s uncertain tax positions. In addition, the IRS indicated it is evaluating the option to seek new


July 2010

legislation to impose a separate penalty for failure to file the schedules or make adequate disclosures. Presumably, any such penalty would have a reason-able cause exception for a good-faith effort to make the required disclosures.

What “uncertain tax positions” must be reported on Schedule UTP? The Schedule UTP requires the report-ing of a corporation’s federal tax positions for which the corporation or a related party (i) has recorded a reserve in an audited financial statement, or (ii) those tax posi-tions taken by the corporation in a tax return for which a reserve has not been recorded by the corporation or a related party based on (a) an expectation to litigate, or (b) an IRS administrative practice.

What is an “audited financial statement” for pur-poses or recording a reserve? A tax position must be reported regardless of whether the audited financial statement is prepared based on GAAP, International Financial Reporting Standards (IFRS) or other country-specific accounting standards, including a modified version (e.g., modified GAAP) that requires a taxpayer to record a reserve for federal income tax positions.

Related-party rule—reporting tax positions recorded as a reserve by a related entity. A related party is any entity that is related to the corporation under Code Sec. 267(b), 318 or 707(b) or any entity that is in-cluded in a consolidated audited financial statement in which the corporation is included. For example, Corporation A, a U.S. corporation has $20 million of assets, and if Corporation B is a foreign business not doing business in the United States, then Corporation be is a related party to Corporation A. Corporations A and B issue their own audited financial statements. If Corporation A has taken a tax position in a tax return, but does not record a reserve with respect to that position in its own audited financial statements, that tax position must be reported by Corporation A on its Schedule UTP if the audited financial statements of Corporation B include a reserve with respect to that tax position.

Consolidated return rule—reporting tax positions recorded as a reserve on consolidated financials. Corporation C files a Form 1120 and has assets of $20 million, and corporation C and D issue a consoli-dated audited financial statement, but they do not file a consolidated tax return. Corporation C has taken a tax position for which a reserve was recorded in the consolidated financial statements of corporations C and D. The tax position taken by Corporation C on its tax return must be reported on its Schedule UTP because a reserve was recorded for its tax position in

a consolidated audited financial statement in which Corporation C was included.

What does the phrase “recording a reserve” mean? The instructions provide some guidance as to the meaning of the phrase by providing that a corpora-tion or related party records a reserve with respect to a tax position taken by the corporation when any of the following occurs in an audited financial statement of the corporation or related party: (i) an increase in a liability for income taxes payable or a reduction of an income tax refund receivable with respect to the tax position; (ii) a reduction in a deferred tax asset or an increase in a deferred tax liability with respect to the tax position; or (iii) both. The initial recording of a reserve will trigger reporting of a tax position, but sub-sequently reserve increases or decreases with respect to a tax position taken in a tax return will not.

What does the phrase “tax position taken in a return” mean? A tax position taken in a tax return means a tax position that would result in an ad-justment to a line on that tax return (or would be included in a Code Sec. 481(a) adjustment) if the position is not sustained.

What “unreserved tax positions” must be report-ed? The question whether a unreserved tax position must be reported on Schedule UTP is dependent on the corporation’s or related party’s reasons why a tax position was not reserved on the audited financial statements. Thus, if the reserve was not recorded on the audited financial statement because the corpora-tion or related-party expectation to litigate or on an IRS administrative practice the unreserved tax posi-tion must be reported on Schedule UTP.

What does the phrase “reserve not recorded based on expectation to litigate” mean? A tax position must be reported on Schedule UTP for which a reserve was not recorded in the audited financial statement after the taxpayer or a related party determines that, if the IRS had full knowledge of the tax position it is unlikely a settlement could be reached—for this purpose, a settlement is unlikely if the probability of settlement is less than 50 percent.

The instructions to the Schedule UTP provides the following example: A corporation takes a position that it can exclude certain income from its 2010 tax return. On September 30, 2010, the corporation determines that if the IRS had full knowledge of the tax position, there is a less than 50-percent probability of settling the issue. The corporation also determines that if the tax position were litigated, it has a 60-percent probability of prevailing in the litigation. Based upon these de-

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terminations, the corporation did not record a reserve for the tax position. Because the corporation made a decision not to record a reserve with respect to its 2010 tax position based on a determination consistent with applicable accounting standards, it will litigate rather than settle the issue with the IRS; the corpora-tion will prevail in the litigation. Because the decision was made more than 60 days before filing its 2010 tax return, the corporation must report this position on the Schedule UTP with its 2010 tax return.

What does the phrase “reserve not recorded based on administrative practice” mean? A tax position required to be reported on Schedule UTP will also include a tax position for which a reserve would have been recorded in the audited financial state-ment but for a determination that, based upon past administrative practices and precedents of the IRS in dealing with the tax position of the taxpayer or similar taxpayers, the IRS has a practice of not challenging the tax position during an examination.

What are the disclosure requirements of the new Schedule UTP? The instructions to the Schedule UTP provide that once a corporation has decided it has tax positions that must be reported, it must provide certain types of information about the tax position.

The Code sections implicated by the position. The corporation must provide the primary Code sections (up to three) relating to the position.

A concise description of the tax position and year tax position taken. Part III (Concise Descriptions of Uncertain Tax Positions) must be completed for every tax position listed in Part I (Uncertain Tax Positions for the Current Tax Year) or II (Uncertain Tax Positions for Prior Tax Years). The instructions provide that a concise description of the tax position includes information that reasonably can be expected to apprise the IRS of the identity of the tax position and the nature of the uncertainty. The description must include a statement that the position involves an item of income, gain, loss, deduction or credit against tax; and a statement regard-ing whether the position involves a determination of the value of the property or right or a computation of basis, and the rationale for the position and the reasons for determining the position is uncertain. In most cases, the description should not exceed a few sentences. The tax year the tax position was taken in a prior year must also be identified on the Schedule UTP.

Information from related parties. If the corporation is unable to obtain sufficient information from one or more related parties and was therefore unable to determine whether a tax position taken in the current

year or in a prior year’s tax return was required to be reported on Part I or II of Schedule UTP, it must check a box in Part I or Part II, as the case may be, to notify the IRS.

Timing codes. The corporation is instructed to iden-tify whether the tax position is a temporary difference (check T) or a permanent difference (check P). The categorization as a temporary or permanent differ-ence, or both, must be consistent with the accounting standards used to prepare the audited financial state-ments. An example of a temporary difference would be an expenditure in which the corporation claims the entire amount as a deduction on its tax return and then determines that it is uncertain whether the expenditure should instead be amortized over five years and records a reserve with respect to such posi-tion in the year it claimed the deduction. An example of a permanent difference would be an expenditure in which the corporation takes the position that the expenditure should be amortized over five years and the corporation then determines it is uncertain whether any deduction or amortization is allowable.

Passthrough entity EIN. If the tax position taken by the corporation relates to a tax position of a passthrough entity, the instructions direct the corpo-ration to enter the EIN of the passthrough entity on Schedule UTP. For example, if the corporation is a partner in a partnership and the tax position involves the partner’s distributive share of an item of income, gain, loss, deduction or credit of the partnership, the EIN of the partnership should be reported to the IRS.

Administrative practice. The instructions provide that the corporation must also tell the IRS (by check-ing a box) if the tax position must be reported because it was determined the IRS would not challenge the position upon examination based on the IRS admin-istrative practice.

Maximum tax adjustment. The instructions provide that the corporation must determine the maximum tax adjustment amount (MTA) for each tax position that is not a valuation tax position or a transfer pric-ing tax position. The MTA for a tax position taken in a tax return is an estimate of the maximum amount of potential U.S. federal tax liability associated with the tax year for which the tax position was taken. The MTA is determined on an annual basis.

For tax positions that relate to items of income, gain, loss or deduction, the corporation must estimate the total amount in dollars and multiply by 0.35 (35 percent). For items of credit, the total amount of credit must be estimated in dollars. The dollar estimates


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related to all applicable items of income, gain, loss deduction and credit can then be combined to deter-mine the MTA of that tax position. For example, the MTA for a tax position taken in a tax return claiming a $100 deduction is $100 x 0.35, or $35.

The MTA for a tax position taken in a tax return claiming a $50 credit is $50. The MTA does not include interest or penalties, and the effects of a tax position on state, local or foreign taxes are disregarded when computing the MTA. Each item of income, gain, loss, deduction or credit relating to a tax position taken in a tax return is determined separately and may only be offset by other items relating to such tax position. For example, if a $100 deduction is associated with a tax position taken in a tax return, enter $35 on Schedule UTP, even if that deduction is used to offset $100 of income generated by general operations of the business. Likewise, if $200 of income is associated with a tax po-sition taken in a tax return, enter $70 ($200 x 0.35) on Schedule UTP, even if the $200 of income was offset by $200 of net operating losses. Items of income, gain, loss, deduction or credit associated with a tax position may offset each other in determining the MTA for that tax position. For example, if income of $100 is associated with a tax position taken in a tax return, and a deduction of $300 is associated with the same tax position, then the MTA is $70 [($300 – $100) x 0.35].

Affiliated groups. The determination of the MTA for a tax position taken in a tax return by an affiliated group is to be determined at the affiliated group level and must take into account all items of income, gain, loss, deduction or credit with respect to that tax posi-tion for all members of the affiliated group.

Transfer pricing and valuation tax positions. A de-termination of a maximum tax adjustment amount is not required for valuation or transfer pricing positions. Instead, the MTA reporting requirement is satisfied by indicating whether the tax position is a valuation or transfer pricing position and by providing a rank-ing of these positions based on either the amount recorded as a reserve for U.S. federal income tax for that tax position taken in the tax return, or the estimated adjustment to U.S. federal income tax that would result if the tax position taken in the tax return is not sustained. For tax positions that relate to items of income, gain, loss and deduction, estimate the total amount in dollars and multiply by 35 percent. The corporation may choose either method and is not required to describe the method chosen or report the reserve or adjustment amounts for the reported positions. The method selected must be consistently

applied to all valuation tax positions and transfer pricing positions reported on the Schedule. The rank-ings should be done separately for the valuation tax positions and the transfer pricing tax positions.

Unit of account. A unit of account is the level of detail used in analyzing a tax position, taking into ac-count both the level at which the taxpayer accumulates the information to support the tax return and the level at which the taxpayer anticipates addressing the issue with the IRS. The unit of account used by a GAAP or modified GAAP taxpayer for reporting at tax position on Schedule UTP must be the same unit of account used by the taxpayer for GAAP or modified GAAP.

In the case of audited financial statements prepared under other accounting standards, a unit of account based on an entire tax year or entire income tax return for a tax year may not be used as the basis for determining a tax position to be reported as IFRS. In such cases, a unit of account used as the basis for determining a tax position to be reported on Schedule UTP is any level of detail that is consistently applied and reasonably based on the items of income, gain, loss, deduction or credit.

Reporting current year and prior year tax positions. Tax positions taken by the corporation in the current year’s tax return for which the decision whether to record the reserve was made at least 60 days before filing the tax return are reported on Part I (Uncertain Tax Positions for the Current Tax Year). Tax positions taken by the corporation in a prior year’s tax return for which the decision whether to record the reserve was made at least 60 days before the filing the tax return are reported on Part II (Uncertain Tax Positions for Prior Tax Years). A corporation is not required to report a tax position it has taken in a prior tax year if the corporation reported the tax position on a Sched-ule UTP filed with a prior year tax return.

Multiple tax positions impacting more than one tax return. If a transaction results in tax positions taken in more than one tax return (and a decision whether to reserve has been made), the tax positions arising from the transaction must be reported on Part I of the Schedule UTP attached to each tax return in which a tax position resulting from the transaction is taken regardless of whether the transaction was disclosed in a Schedule UTP file with a prior year’s tax return. The instructions add: Do not report a tax position on a Schedule UTP before the tax year in which the tax position is taken in a tax return for the corporation.

Transition rules—no retroactive filing. A corpora-tion is not required to report on Schedule UTP a tax

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position taken (i) in a tax year beginning before De-cember 15, 2009, or (ii) a tax year beginning on or after December 15, 2009, and ending before January 1, 2010, regardless of when a reserve was recorded with respect to that tax position. For example, a cor-poration incurs an expenditure in 2009 and taken the position the expenditure may be amortized over five years beginning in its 2009 tax return. For this purpose, the corporation has taken a tax position in each of the five tax years (2009 through 2013) because in each year’s tax return there would be an adjustment to a line item on that return if the position taken in that year was not sustained. However, the corporation should not report the tax position in the 2009 tax year because it was taken in a tax year beginning before December 15, 2009. Because the corporation recorded a reserve more than 60 days before filing its tax returns for tax years 2010 through 2013, the tax position taken in each of those tax years must be reported on Part I of the Schedule UTP filed with the tax return for the respec-tive tax year in which the position was taken.

Unanswered questions. If in the future, the UTP reporting is expanded to include uncertain tax posi-tions relating to Chapter 3 and 4 withholding taxes, will the IRS have a road map for detailed reporting and withholding tax audits? It is an still an open question whether our treaty partners or state or local taxing au-thorities will also decide this new expanded reporting or some variant on it is a good compliance and audit device and will decide to adopt their own reporting requirements for uncertain tax positions under their foreign or local laws in the near future. (It is the au-thor’s understanding Commissioner Schulman also discussed the new reporting requirement with several of his European counterparts shortly after his speech to the New York State Bar Tax Section on January 26, 2010.) Query: Will the IRS, when armed with this new information, also seek to dig deeper into transactions to find out how the counterparty on the other side reported the transaction for tax purposes?18

It is still an open question as to how Schedule UTP reporting will impact future audits, appeals, amended returns, APA agreements and other administrative and tax controversy matters with the IRS. Will the disclosures create more confusion on the issues, and how will the IRS use this information?19 What will tax preparers re-quire of corporations and other taxpayers to substantiate their uncertain tax positions to avoid preparer penal-ties, and will the tax return reconciliation work papers be subject to disclosure to the IRS, or can a privilege apply? Will the taxpayer have to reevaluate and docu-

ment all its tax positions in light of the new disclosure requirements? Will the disclosure generate more IDRs and summons by the IRS, and will the identification of the maximum amount of the potential tax liability create a higher bar for settlement? If the maximum amount is to be adjusted for NOLs, credits and other correlative adjustments in the current year and in other years, how will this offset properly be determined?

Will audit committees and corporate boards and senior management be charged with a new responsi-bilities to review and approve the Schedule or at the very least be aware of its contents? Will there be any exemptions or carve-outs from having to complete the schedule (e.g., compliance assurance program)? Will there be any relief from penalties if the schedule is erroneous, partially completed or not filed on a timely basis? Will failure to file the Schedule or to properly report all uncertain tax positions constitute the failure to file a complete tax return for statute of limitations purposes, and will the taxpayer be required to com-plete this Schedule in order to secure a tax refund for income and withholding tax purposes?

Applicability to Chapters 3 and 4 withholding regimes. Presumably, the Treasury at some point in the future will broadly interpret these rules to apply to both Chapter 3 (withholding of tax on nonresident aliens and foreign corporations) and Chapter 4 (new Code Secs. 1471–1474) of the new law even though the announcement relates to the “determination of any United States federal income tax liability.” However, ASC 740-10-15-4 indicates that a withholding tax for the benefit of recipients of a dividend is not an income tax for GAAP purposes. An argument could be made that other Chapter 3 withholding taxes attributable to U.S.-source FDAP income (e.g., certain interest, royalties and other payments), as well as Chapter 4 withholding taxes attributable to U.S.-source “with-holdable payments,” are not an income tax liability for purposes of IRS Announcement 2010-9. Any contingent liability is generally recorded for GAAP purposes under FAS 5 and not FIN 48.

Background: The UBS CaseOn August 12, 2009, it was reported that UBS AG (UBS) and the U.S. Department of Justice (DOJ) settled the dispute over the disclosure of UBS clients’ names that arose under a civil petition to force UBS to disclose the U.S. account holders’ identities. On August 19, 2009, UBS entered into a formal agreement to turn over the names of 4,450 American clients holding undisclosed


July 2010

offshore accounts at UBS. According to a new York TiMes article,20 these accounts held over $18 billion at one point. The new York TiMes article suggested that the biggest accounts will be targeted—some containing hundreds of millions of dollars and accounts that made use of offshore entities and sham corporations.

The DOJ had originally requested UBS to turn over the identities of 52,000 offshore accounts so that they could investigate tax evasion, which presumably would be easy to prove if the U.S. persons did file any FBARs for the accounts, or not admit the existence the offshore bank account on their U.S. tax returns and/or didn’t report the income from these accounts on their U.S. tax returns.

It can be expected that the DOJ will continue to follow up aggressively to prosecute U.S. taxpayers who have undisclosed accounts in UBS and other

foreign banks or their in-termediaries, whether or not these accounts have been owned directly or through their controlled offshore entities.21 As part of this prosecution effort, it is likely the DOJ and the IRS will not only prosecute the U.S. taxpayers who are the owners or who have signature or other author-ity over such accounts, but also the officers and directors of those financial service companies and promoters, consultants and other professionals who helped to set up or facilitate these structures for these taxpayers.

This UBS settlement fol lowed a Deferred Prosecution Agreement (DPA), which was en-tered into between UBS and the DOJ on February 18, 2009, in settlement of the criminal prose-cution of UBS by the government. Under this agreement, UBS agreed, among other things, to pay $780 million in taxes

and penalties and to fully cooperate with the govern-ment’s ongoing criminal investigation of the offshore accounts and the release of 255 names of American offshore account holders, which has started the investigation of 150 UBS offshore clients, three criminal convictions and one indictment.

On January 5, 2009, the Swiss Federal Adminis-trative Court held that FINMA, the Swiss financial supervisory authority, was not entitled to give the information regarding 280 U.S. clients of UBS to the IRS. However, at the date of the decision the name of the U.S. clients had already been released. On January 20, 2009, the Swiss court brought into question the settlement with the DOJ. In the Court’s ruling in favor a U.S. taxpayer, a court panel said that UBS files on 4,450 private bank clients shouldn’t be turned over to the U.S. authorities

Exhibit 1.

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because the failure by bank clients to prepare Form W-9s did not constitute tax fraud under Swiss law. It is expected that the Swiss and U.S. authorities will attempt to work out a settlement that enables UBS to release the client names as contemplated by the DPA rather than having to go back to U.S. District Court and enforce the DOJ’s John Doe summons against UBS.

UBS DPA Requirements—Increased Corporate Governance and ComplianceAs part of the DPA, UBS also agreed to several provi-sions related to corporate governance and satisfying its compliances obligations, including (i) exiting its U.S. cross-border business, which will be overseen by its Board of Directors; (ii) requiring UBS to provide banking and securities services to its U.S. clients solely through SEC registered subsidiaries or affiliates; (iii) obtaining executed IRS information reporting forms (e.g., Forms W-9s); (iv) sending correspondence to their clients of the cross-border business informing them that their accounts will be closed and if funds are to be transferred to another UBS account that a Form W-9 for the account must be provided; (v) maintaining a compliance program regarding its duties under the qualified intermediary agreement with the IRS; (vi) implementing a revised governance structure for the legal and compliance functions; and (vii) engaging an external auditor to monitor compliance with the exit program under the DPA and qualified intermediary agreement with the IRS.22

DOJ Investigations of Foreign Banks May Go Beyond UBSThe press23 recently reported that the DOJ is now exam-ining 7,000 accounts from foreign banks beyond UBS and that the number of individuals coming forward as part of the U.S. tax amnesty program is now up to more than 16,000 individuals. The government said it will use all these information leads to find patterns to prosecute more individuals and possibly other banks. Kevin Downing, a DOJ lawyer, stated, “We are now getting documents from foreign banks that have never been produced before. The 7,000 plus accounts are from banks in Switzerland and elsewhere. In the next couple of years you’ll see the system flooded with these cases. That could bring in tens of thousands of cases.”

Purpose of New LawThe stated purpose of the new law is to “clamp down on tax evasion and improve taxpayer compliance by giving

the Internal Revenue Service new administrative tools to detect, deter and discourage offshore tax abuses.”24 The Congressional sponsors joint statement said, “The Foreign Account Tax Compliance Act would force foreign financial institutions, foreign trusts, and foreign corporations to provide information about their U.S. ac-count holders, grantors, and owners, respectively.”25

The new law does not directly focus on tax evasion and does not amend either the criminal or civil penal-ties for tax evasion, nor changes the penalties for aiding and abetting for understatements of tax or tax evasion (but does change the statute of limitations from three years to six years for assessments of tax under the new regime; see “New 6-Year Statute of Limitations Applies to Chapter 4 Withholding Taxes”).

However, the new regime imposes significant new reporting and disclosure obligations on foreign financial institutions (regardless of whether it has a “qualified intermediary”) and nonfinancial foreign entities, which will be enforced through a new with-holding tax regime and substantial penalties.

Members of Congress and commentators have asked that the Treasury measure if the new enforce-ment tool in the law is working to combat tax evasion by U.S. persons, even though the new law imposes no measurement requirement whatsoever, and can be expected to impose significant burdens on the global financial system to satisfy the new requirements and to try to achieve its goal.

More specifically, the new regime will impose a broad-based 30-percent withholding tax on all U.S.-source “withholdable payments” received by a foreign financial institution, unless the foreign fi-nancial institution and each of its financial affiliates enter into an agreement with the Treasury to provide certain customer financial account information. In addition, the new regime creates a new reporting system that will require withholding agents making payments to nonfinancial foreign entities to obtain certain customer information of each substantial U.S. owner and report this information to the Treasury. Many (but not all) of the withholding and information tax reporting provisions that were in the proposed FATCA legislation were incorporated into the HIRE Act and certain new provisions were added to the law as discussed below.

The new law would also treat a “dividend equiva-lent” as a dividend from U.S. sources subject to U.S. withholding tax. The term “dividend equivalent” will mean any substitute dividend or any payment made under a notional principal contract and any other


July 2010

payment determined to be substantially similar to a substitute dividend or a specified notional principal contract. See “Substitute Dividends and Dividend Equivalent Payments Received by Foreign Persons Treated as Dividends—New Code Sec. 871.”

In addition, under the new law, a deduction for interest is disallowed with respect to any obligation not in registered form unless that obligation is issued by a natural person, matures in one year or is not of a type offered to the public. The new law also repeals the treatment as portfolio interest any interest paid on bonds that are not issued in registered form but that meet the foreign targeting requirements of Code Sec. 163(f)(2)(B).26 The law preserves the ordinary income treatment of any gain realized by the beneficial owner from the sale or other disposition of a registration-required obligation that is not in registered form and preserves the exception to the registration require-ment for excise tax purposes for such obligations. See “Repeal of Certain Foreign Exceptions to Registered Bond Requirements.”

Goals of the New LawThe new law’s goal is to stop offshore tax evasion. The White House,27 the Treasury28 and Congress29 view the legislation as a timely and essential effort to stop offshore tax evasion by U.S. persons who hide income and assets offshore, and commentators have applauded this as leveling the playing field so that all Americans must honor their obligations.

ABA Tax Section Comments on Goals of LegislationThe ABA Tax Section Comments discussed the pur-pose and goals of the proposed FATCA legislation by stating:30

The goal of the Bill as a whole, and Section 101 of the Bill in particular, is to impede offshore tax evasion by U.S. persons. The provisions would bolster the government’s arsenal in that effort and would make it more difficult for U.S. persons to hide income and assets offshore. We applaud the efforts of Congress and the Administration in this endeavor.

We believe that the Bill would serve the purpose well by extending substantially the information re-porting regime currently in place. Although the Bill would impose heavy costs and burdens on financial intermediaries, we believe the extend information

reporting regime generally would be workable, subject to our specific comments below.

The new law is an improvement. Many view the new law as an improvement over earlier drafts of proposed legislation31 since it no longer targets coun-tries and offshore secrecy jurisdictions (e.g., black lists) and omits the overly broad entity classification provisions and foreign tax credit limitations, but rather provides beneficial tools for the government to individuals who seek to evade their U.S. tax re-sponsibilities by using foreign financial institutions and nonfinancial foreign entities to provide the information the Treasury needs to enforce the tax laws. However, because foreign financial institutions will likely have to expend significant resources to implement the law, commentators have encouraged efforts by the Treasury to streamline the reporting and disclosure process wherever possible.

ABA Tax Section Comments on improvements of legislation. The ABA Tax Comments also felt that the predecessor FATCA legislation was an improvement by stating:32

The Bill is an improvement in our view over earlier proposed legislation having a similar overall pur-pose, because an approach relying on increased reporting is far more likely to be effective than approaches such as targeting certain countries by creating blacklists. We recognize, however, that for increased information reporting to be effec-tive the information must be provided in a way that can be processed, accessed and compared with other data in the systems maintained by the Internal Revenue IRS (“IRS”). To the extent the Bill would make it easier for the government to iden-tify that relatively small number of individuals who seek to evade their U.S. tax responsibilities by using FFIs [“foreign financial institutions”] and nonfinancial foreign entities (“NFFEs”), we anticipate a salutary deterrence effect.

Background of legislation. The ABA Tax Section Comments provided the following explanation for the proposed FATCA legislation which very likely holds true for the new law as well:33

Section 10134 of the Bill would dramatically change the withholding tax regime by imposing a 30 percent withholding tax on U.S. source pay-ments and gross proceeds from the sale of any

40


equity or debt instrument issued by a U.S. issuer made to foreign entities, whether as nominee or as beneficial owner. The withholding tax could be avoided only if the foreign entity and its U.S. account or interest holders comply with extensive new reporting requirements.

The intended targets of this change are those relatively few U.S. individuals who otherwise would attempt to avoid U.S. tax on income through foreign intermediaries or foreign ben-eficial owned entities. The revenue estimate at the Joint Committee on Taxation is $8.5 billion [which now was revised downward to $7.67 billion because of the extension of the effective date provisions35]. No doubt, the vast majority of Americans are upset that, as reported in the press, certain individuals have avoided their income tax obligations through the use of offshore accounts. Self-reporting alone has proved inadequate.

There has been a dramatic proliferation of informa-tion exchange agreements, but relying on those agreements alone has proved insufficient. The fac-tors that appear to affect the utility of information exchange agreements include the requested gov-ernment’s lack of access to the information under its own laws, the requirement that the requesting government identify specific facts relevant to cases for which the information requested, the (at best) delay in obtaining the information, and the fact that the data often would not be in a computer-accessible form. Accordingly, an approach based on expanded third-party intermediary reporting (even one that is backed up by a withholding re-quirement, as here) is not unreasonable, although it would result in significant compliance burdens on financial intermediaries and on foreign enti-ties generally.

Overview of the new withholding and report-ing regime. The ABA Tax Section Comments on the proposed FATCA legislation provides insight into the objective and approach the drafters to the new law took to solve the problem of tax evasion by some Americans by stating:36

The overall objective of the proposals is to im-prove compliance by having in place a system to obtain third party reporting concerning foreign financial accounts of U.S. persons, including

those owning investments through closely held foreign entities. Obtaining such information can only be accomplished with the assistance of FFIs and other entities, but currently such institutions generally have no obligation or incentive to pro-vide information.

The Bill’s approach to this problem, which is based on the Obama Administration’s budget proposals, is to establish a withholding tax regime (“FATCA withholding”) as a “stick” to obtain information about U.S. ownership of foreign accounts and entities and payments to such account owners and entities. The omitted action or failure triggering withholding would not necessarily have any relevance to the sta-tus of the beneficial owner of the income, and would not necessarily even be a failure by such beneficial owner, and the amount withheld often would bear no relationship to any income that is taxable. The withheld tax, could, depending on the nature of the underlying payments (other than in the case of non-treaty eligible beneficial owner financial institutions), be refundable even if the failure giving rise to the withholding were not remedied. Thus, the proposed regime bears some resemblance to the backup withholding regime, but in effect is quite different.

The proposed regime would be buckled onto the existing tax regimes. To the extent FATCA withholding would not be required the “normal” withholding tax rules would continue to apply. To the extent FATCA withholding would be required (due to noncompliance), withholding would not be required under the normal withholding tax rules, but to obtain a refund (if permitted) the normal regime would be applicable.

Mechanics of new “Chapter 4.” The touchstone of the new law is to impose upon a foreign financial institu-tion a 30-percent withholding tax if it fails to provide the information required under the so-called Code Sec. 1471(b) agreement. See “General Requirements to Avoid Withholding.” The idea behind the new re-gime is to coerce foreign financial institutions to report information about their U.S. customers and account holders to the IRS. As an alternative, a foreign financial institution can elect to comply with Form 1099 reporting after applying the assumption that each account holder who is a specified U.S. person or a U.S.-owned foreign


July 2010

entity is a U.S. citizen. See “Election to be Subject to the same Reporting as United States Financial Institutions.” Because disclosure is sought from foreign financial enti-ties that themselves may not be subject to U.S. tax, the information reporting cannot be mandated in a rule of law but must be incentivized.37

In addition, in a companion set of provisions, a withholding agent will be required to withhold 30 percent from any withholdable payment made to a nonfinancial foreign entity that fails to obtain from the beneficial owner or the payee a certification that the beneficial owner does not have any substantial U.S. owners, or otherwise satisfies the information report-ing requirements by providing the name, address and TIN of each substantial U.S. owner and affirms that the withholding agent does not know, or have reason to know, that such information is incorrect. In this case, the new law is intended to require a nonfinancial foreign entity receiving U.S.-source income to report information about its beneficial owners to the IRS. See “Withholdable Payments to other Foreign Entities.”

Under the new law, the toggle to switch off the withholding requirements for a foreign financial institution would depend upon satisfying the infor-mation, verification and other requirements found in a Code Sec. 1471(b) agreement with the IRS. See “General Requirements to Avoid Withholding.” On the other hand, a nonfinancial foreign entity would have a separate toggle to switch off its withholding requirements, which is dependent upon satisfying the certification or disclosure requirements under a separate set of provisions of the new law. See “With-holdable Payments to other Foreign Entities.”

A withholdable payment includes fixed determin-able and periodical income or “FDAP,” as well as the gross proceeds from the sale of any property that can produce interest or dividends from sources within the United States. See “Withholdable Payment.”

The withholding agent with respect to a payment to a foreign financial institution and with respect to a payment to a nonfinancial foreign entity is liable for the tax, but is indemnified against the claims and demands of any persons for the amounts of any payments made under the new law. See “Liability for Withheld Tax.”

Dual withholding not required. Dual withholding would not be required under the new law or the pre-ceding withholding rules, and the Treasury has been directed to prescribe rules to avoid duplication of the withholding taxes in the case of any overlap. Rather, new Code Secs. 1471–1474 would be integrated into the existing withholding tax regimes. Thus, to the

extent withholding is not required under the “new” provisions, the “old” withholding tax rules continue to apply. However, it is likely that the information report-ing required under Chapter 3 of the Code will have to be revamped and integrated into the new Chapter 4 information reporting regime. For this purpose, the existing withholding tax rules would not only include Code Sec. 871 (dealing with withholding tax for non-resident alien individuals) and Code 881 (dealing with withholding tax for foreign corporations), but also Code Secs. 1441–1442 (dealing with withholding of tax on nonresident aliens and foreign corporations), Code Sec. 1445 (withholding on the disposition of U.S. real property interests) and Code Sec. 1446 (dealing with withholding on foreign partners’ share of effectively connected income). See “Credits and Re-funds under New Code Secs. 1471-1474 Determined in same Manner as Chapter 3 Withholding.”

FATCA legislation is in addition to qualified in-termediary requirements. The new law’s reporting and other requirements under a Code Sec. 1471(b) agreement would be in addition to any requirements imposed on an institution that is a “qualified interme-diary,” or “QI.” There are estimated to be about 5,600 financial institutions and banks38 that have entered into QIs with the IRS who have already developed extensive recordkeeping systems to categorize non-U.S. custom-ers into different tax categories and either deduct the withholding tax themselves or send the information on the investors to another bank. That bank, which is typically a U.S. global custodian, would then deduct the correct amount of tax. These QIs, however, never in the past had to reveal to the IRS the names of U.S. citizens, green card holders or U.S. companies that invest directly in foreign assets. Rather, the U.S. inves-tor was required by law to disclose any account in foreign assets in an FBAR39 and voluntarily report any income earned on such accounts on its U.S. income tax returns.40 See “Code Sec. 1471Requirements are in addition to Section 1441 Reporting Requirements.”

While the requirements imposed by the new law, which are modeled after the proposed FATCA provisions, are significant, the press release accompa-nying the predecessor FATCA legislation indicated that “[i]t is expected that foreign financial institutions would comply with these disclosures and reporting require-ments in order to avoid paying the withholding tax.”41

Thus, foreign financial institutions that have ro-bust and well-developed information reporting and compliance infrastructure will likely be strained to integrate the new Chapter 4 reporting and withhold-

42


ing regime with the information reporting required as a QI. See “Code Sec. 1471Requirements are in addi-tion to Code Sec. 1441 Reporting Requirements.”

Umbrella structures. Because a financial institution, multinational company or other complex fund structure may own or have voting rights in literally hundreds, if not thousands, of foreign entities (hereinafter termed the “umbrellas structure”), there undoubtedly will be issues as to how apply the new Chapter 4 disclosure, reporting or withholding regime to these entities, and Treasury guidance will be needed.

As a preliminary matter, foreign entities in the umbrella structure will have to be categorized as (i) foreign financial institutions subject to the new with-holding and reporting regime under new Code Sec. 1471; (ii) nonfinancial foreign entities subject to the new withholding, certification or disclosure regime under new Code Sec. 1472; or (iii) foreign entities that are not subject to the withholding requirements under new Chapter 4 because they have no “withholdable payments” under new Code Sec. 1471 or new Code Sec. 1472 or are otherwise subject to an exemption from withholding. See “Withholdable Payments to Foreign Financial Institutions” and “Withholdable Payments to other Foreign Entities.”

A foreign financial institution means a foreign entity that (i) accepts deposits in the ordinary course of a banking or similar business; (ii) holds financial assets for the account of others as a substantial portion of its business; or (iii) is engaged (or holding itself out as being engaged) primarily in the business of invest-ing, reinvesting, or trading in securities interests in partnerships, commodities or any interest (includ-ing a futures or forward contract or option) in such securities, partnership interests or commodities. See “Financial Institution.”

The foreign financial entities that are categorized as financial institutions will have to be analyzed to deter-mine if they are part of an “expanded affiliated group” with U.S. account holders and therefore potentially subject to the new reporting and withholding regime generally on consolidated reporting and withholding basis. Thus, it is possible for entities in an umbrella structure to have a “parent” foreign financial institu-tion and a group of foreign financial institutions in the “expanded affiliated group,” which will generally withheld and report as one foreign financial institu-tion, and several separate stand-alone foreign financial institutions that are outside the parent’s “expanded affiliated group” because they do not meet the vot-ing and value tests under the new provision, yet are

nonetheless subject to new Code Sec. 1471 and in fact may have their own “expanded affiliated group” to withhold and report for their own U.S. accounts.

The Treasury will likely have to provide guidance to deal with complex umbrella structures where both foreign financial institutions and nonfinancial foreign entities are in the direct or indirect chain of owner-ship in the umbrella structure to avoid duplication of reporting. Presumably, it is in Treasury’s best interests to include as many entities in the foreign financial institution “expanded affiliated group” as possible in order to obtain the maximum amount of information for the umbrellas group’s U.S. accounts unless the risk of tax evasion is minimal. See “New Code Sec. 1471 Applies to Expanded Affiliated Group.”

The reporting and withholding regime applicable to foreign financial institutions will not apply to certain payments, including payments to foreign governments, any political subdivision, international organizations, wholly owned agencies or instrumentalities thereof, foreign central bank or other class of persons the Treasury identifies as posing a low risk of tax evasion. Apparently, however, a wholly (or partially) owned agency or instrumentality of a foreign central bank is not an exempt payee under new Code Sec. 1471(f). See “Exception for Certain Payments.”

Among other requirements, a foreign financial institution will have to obtain annual information for each U.S. account to avoid the imposition of a 30-percent withholding tax on “withholdable pay-ments,” unless an exception otherwise applies. This includes the name, address, TIN, account number, account balance and, at the discretion of the Treasury, the gross receipts and gross withdrawals from each U.S. account. See “Annual Reporting Requirements for Foreign Financial Institution.”

Need to identify detailed annual information about global accounts. A foreign financial institu-tion and its expanded affiliated group will have to “survey” its global accounts and categorize the accounts as either (i) U.S. accounts, or (ii) foreign accounts. According to at least once commentator,42 “[m]ost large global banks maintain separate da-tabases on investors and investments made. These can be data bases for each branch office or for each type of investment, such as equities, fixed-income products or derivative securities. On average … a global bank would easily have at least a dozen or so counterparty repositories holding information on customers and their investments. And the infor-mation may be inconsistent and incorrect. Branch


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offices also may have different policies reflecting legal requirements in their home markets.”

Eric Bass from Rothstein Kass framed the issue by stating:

The bank or other foreign intermediary will need to know where the records of ownership of for-eign shares of U.S. investors are kept and set up new and consistent procedures for account open-ing and updating … Although it is unlikely that a financial firm could quickly consolidate such information in a single repository, it still has to set up a centralized virtual committee to determine the procedures required and consistent basis.

Importantly, the new law will require foreign financial institutions to not only obtain detailed infor-mation about their legacy global accounts and when the customers open their accounts, but also through-out the lifetime of the accounts including the gross receipts and gross withdrawals from the accounts (unless Treasury provides guidance otherwise) until these accounts are closed. Presumably, this tracking would also include transfer between accounts owned by the same customer and quite family members and family-owned legal entities.

In addition, when dealing with multiple reposito-ries, critical decisions will have to be made about who has access to the investor accounts at the foreign financial institution and the supporting repositories which may be maintained by custodians, intermediar-ies, and other agents of the bank and how the investor information will otherwise be protected by firewalls and other internet-based protection tools to avoid inadvertent dissemination of investor information to sources beyond the IRS.

A “U.S. account” is a financial account held by one or more “specified U.S. persons” or a “U.S.-owned foreign entity.” See “U.S. Account and U.S.-owned foreign entity.” A “specified U.S. person” is a U.S. person unless an exception applies such as a publicly traded corporation. See “Specified U.S. person.” A U.S.-owned foreign entity means any foreign entity that has one or more “substantial United States own-ers.” See “U.S.-owned foreign entity.”

Nonfinancial foreign entities. Each nonfinancial foreign entity defined as any foreign entity that is not a financial institution will be subject to the with-holding, certification or disclosure regime under new Code Sec. 1472, unless an exception otherwise ap-plies. See “Withholdable Payment to other Foreign

Entities.” Since the new law does not now have a “expanded affiliated group” provision built into the operative language for nonfinancial foreign entities unless the Treasury by regulation incorporates this concept (which is likely), the nonfinancial foreign entities in the umbrella structure will individually be subject to the new certification or disclosure and withholding regime for nonfinancial foreign entities under new Code Sec. 1472 unless an exception otherwise applies. See “Nonfinancial Foreign Entity Expanded Affiliated Group Issues.”

Each nonfinancial foreign entity can avoid the im-position on the new Code Sec. 1472(a) 30-percent withholding tax if the beneficial owner or the payee provides the withholding agent with either a certifi-cation that such beneficial owner does not have any substantial U.S. owners or provides the withholding agent with the name, address and TIN of each sub-stantial U.S. owner of such beneficial owner and the withholding agent can represent that it does know or has reason to know that such substantial U.S. owner information is incorrect. The new law also provides certain exemptions from withholding, such as pay-ments made to publicly traded corporations or a corporate member of its expanded affiliated group, an entity organized under the laws of a U.S. possession that is wholly owned by bona fide residents, a foreign government, political subdivision, international orga-nization or agency or instrumentality thereof, a foreign central bank of issue (but not an instrumentality or agency thereof) or any other class of persons identified by the Treasury. See “Exceptions from Withholding.”

Commentators have recommended that the simpli-fied reporting regime be tailored to use the “stick” sparingly; namely, the withholding tax should be imposed only in those cases where foreign finan-cial institutions have failed to satisfy the Code Sec. 1471(b) requirements or nonfinancial foreign entities have failed in their information gathering and disclo-sure responsibilities under the new law and should have the opportunity to remedy deficiencies in their processes to be compliant with the new law.

Treasury needs expanded regulatory authority to implement new law. The NYSBA Tax Comments raised the concern that Treasury needs expanded regulatory authority by stating:43 “[W]e strongly urge that the legislation is amended, or the legislative his-tory is clarified, to provide the Treasury Department greater authority to modify the rules and phase in the requirements in a manner that will encourage compli-ance from a broad cross-section of foreign financial

44


entities. This is critical, because the legislation’s suc-cess depends on drawing a large number of entities from each of various categories of foreign financial entities into voluntary compliance and cooperation with the Treasury Department.”

Choice by foreign entities. The NYSBA Tax Section Comments also raised the issue that many foreign entities will be forced to decide whether they want to be subject to the new regime or whether they will avoid doing business with U.S. customers (and presumably investing in U.S. stock or securities for their own account):44

As a general matter, we believe that the Treasury Department will need to take into account, in developing regulatory guidance with respect to these rules, the limitations and concerns of different types of foreign financial entities. While the choice many foreign entities will be forced to confront is the same—(1) comply with the reporting rules (if they are able to do so) or (2) avoid doing business with U.S. customers and abstain from investing in assets that would generate U.S.-source income (un-less the foreign entity chooses to bear the brunt of the withholding tax and gross up its clients for any such withholding)—the reaction of different types of foreign financial entities will vary, depending on the nature of the entity (bank, clearing house, se-curities dealer, public or private investment fund or securitization vehicle), its entity (or affiliated group to which it belongs) operates. For example, while major global banks would likely be compelled for business reasons to comply with the new rules, the requirements may be too onerous for small banks or local investment funds and hedge funds that invest exclusively or primarily in European or Asian markets. Accordingly, in order to attract a critical mass of foreign financial entities into compliance with the new rules, the reporting and withholding systems under Chapter 4 will need to be designed in a nuanced way adaptable to the varying legal, business, geographic, financial and other consid-erations of different types of entities … .

[W]e note that it appeared that, prior to the [Ex-tenders Act], some foreign financial entities were disinvesting from U.S. securities and turning away American customers, based on their perceptions of what the requirements of FATCA would entail … . In many cases, foreign financial entities may resort to such measures not because they are interested in

facilitating US tax evasion but because they do not have the resources or appetite to sustain the costs of compliance with the complex information gather-ing, reporting and withholding provisions under the new reporting and withholding regimes.

Recommend a global approach to international tax compliance. Historically, many U.S. treaty partners have relied upon OECD information sharing to obtain tax information about their citizens offshore accounts. It is the author’s understanding exchange of informa-tion agreements or protocols have been adopted by at least 90 countries. However, in order to obtain such information, the requesting governmental authority must establish that the information is first foreseeably relevant—that is, it must have enough information about the account holder to make such a request in order to prevent a fishing expedition. Having said this, one com-mentator recently suggested the U.S. government could obtain the required information about U.S. accounts if it agrees to enter into the EU Savings Directive.45

It has been recommended by some commentators that the Treasury obtain the conceptual buy-in by U.S. treaty partners for the new law and enter into bi- or multi-lateral agreements providing for direct or inter-governmental information sharing as part of its multi-pronged strategy to international tax compliance. It is likely that the new Chapter 4 rules will create adverse timing and compliance burdens for foreign entities, especially if such entities do not enter into Code Sec. 1471(b) or FFI agreements with the Treasury. See “Withholdable Payments to Foreign Financial Institutions.”

Some commentators have suggested the proposed legislation will result in copycat or other withholding and reporting legislation by other countries, which may inhibit cross-border capital flows. For example, the Swiss Bankers Association last year proposed a so-called universal withholding tax in lieu of imposing a requirement on Swiss banks to check their foreign clients tax compliance—it has been estimated that Swiss banks manage some $2 trillion in offshore funds.46 Under this model, the Swiss bank would levy the tax directly at source on behalf of the foreign country with which an agreement has been signed. The revenue would be forwarded by the Swiss Fed-eral Tax Administration for remittance to the client’s country of domicile, but importantly the identity of the client would only be known to the paying agent. The new tax would be a final tax assessment, mean-ing that after the Swiss bank deducted the tax, the


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client and presumably the Swiss bank would, from the perspective of the offshore taxing authorities, automatically have fulfilled its tax obligation with regard to this income.47

At least one commentator has suggested foreign tax piggy-back legislation can be just as invasive as the U.S. model. If the United States is now asking to know the identities of Americans that own U.S. accounts under the HIRE Act, a foreign financial institution will have to know whether its accounts are owned by specified U.S. persons. To that end, it will be asking global account owners to certify or provide docu-mentation acceptable to the Treasury whether they are specified U.S. persons. For example, if another country, such as China, adopts similar legislation, presumably Americans and other persons who are not Chinese citizens or residents will have to file Chinese tax certifications or other documentation acceptable to the Chinese taxing authorities that they are not Chinese persons (based upon Chinese tax principles) and, if withheld upon, may have to file Chinese tax returns in Mandarin to obtain a refund.

The Treasury may want to consider entering into more robust agreements for information exchange with the intention of partnering up with our treaty partners for assistance in accomplishing the goals of this legislation.

The Treasury, as part of its rulemaking author-ity, is also encouraged to provide clear standards for evaluating exchange of information programs including assessing the extent to which so-called Code Sec. 1471(b) agreements are in compliance with existing U.S. and international standards and the availability of automatic information exchange and the responsiveness of the treaty partner to re-quests for information.

Lastly, some commentators are also concerned that the new law will create an incentive for foreign investors to conduct U.S. securities sales transactions overseas through foreign financial institutions that have no other activities or nexus to the U.S. to avoid the new reporting and withholding tax regime.

II. Increased Disclosure of Beneficial OwnersThe following discussion goes into detail about how the new reporting and withholding regime is intended to work and also comments upon areas in which the Treasury may want to provide taxpayers with addi-tional guidance and clarification.

Reporting on Certain Foreign Accounts—New Code Secs. 1471–1474

New Statutory Framework

The law adds new Chapter 4 (e.g., Code Secs. 1471–1474) to the Code, which provides for with-holding taxes to enforce new reporting requirements on certain foreign accounts owned by specified U.S. persons or by U.S. owned foreign entities.48 See “U.S.-owned foreign entity.” The new law establishes rules for withholdable payments to foreign financial institutions and for withholdable payments to other nonfinancial foreign entities.

Withholding and reporting requirements for pay-ments of U.S.-source FDAP income to foreign persons. The existing withholding tax rules under Chapter 3 of the Code (e.g., Code Secs. 1441–1446) will continue to apply for payments of U.S.-source FDAP income made to foreign persons, as well as the information reporting requirements under Code Sec. 1461 and Chapter 61 of the Code, and the backup withholding procedures and requirements under Code Sec. 3406.49

Liability to withheld and deposit the tax, interest and penalties. Every withholding agent will be per-sonally liable under new Chapter 4. More specifically, every person required to deduct and withhold any tax under new withholding provisions of Chapter 4 will be personally liable for the tax, as well as inter-est and penalties.50 See “Liability for Withholding Tax, Interest and Penalties.” However, such person will also be indemnified against claims and demands of any person for the amount of payments made in accordance with the new law.51 Presumably, the withholding agent will be required to deposit any tax withheld and to file any returns required by the Treasury as part of its responsibilities under the Code Sec. 1471(b) agreement.52

Indemnification of Withholding Agents/Investors FDAP indemnification rules. Under the FDAP with-

holding rules, a withholding agent is indemnified against the claims and demands of any person for the amount of any payments made in accordance with the provisions of Chapter 3 of the Code.53The Trea-sury regulations amplify this provision by providing an indemnity for a withholding agent that withholds based upon a reasonable belief that such withhold-ing is required.54 Under these rules, however, if an overpayment of tax is withheld, the payee would be entitled to file a claim for refund under Code Sec. 1464 so that indemnification may not be required.

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At present, there is no judicial authority to address whether this indemnification is sufficient to protect a withholding agent from suit by a payee for over with-holding. Presumably, the plaintiff would be required to exhaust the administrative remedies for a refund claim and refund suit in the event the IRS denied the refund claim. In DuPont Glore Forgan Inc. v. American Telephone & Telegraph Co.,55 the plaintiff sued for the wrongful over-withholding of excise taxes. The court determined that the exclusive remedy for the wrong was against the government. However, at least one com-mentator believes that the indemnification provided by Code Sec. 1461 that a suit can be brought against a withholding agent contrary to this decision.56

Possible exposure to beneficial financial account owners for over-withholding under new withholding regime. Since the new withholding regime is so broad and requires significant diligence to identify each substantial U.S. owner of any account holder that is a U.S.-owned foreign entity for a foreign financial institu-tion or nonfinancial foreign entity to avoid withholding on any withholdable payments before a payment is made, it can be expected that financial account owners will seek indemnification from withholding agents if erroneous over-withholding occurs and the beneficial financial account owners have their refund claims de-nied by the IRS. See “Credits and Refunds.” In addition, this liability may be extended by the Treasury under the Code Sec. 1471(b) agreements (or by third-party contract indemnity provisions) to other withholding agents, financial intermediaries, administrators, ser-vicers and other professionals who may have diligence, verification, reporting and withholding responsibilities under the new withholding and reporting regime. See “General Requirements to Avoid Withholding.”

Under-withholding issues. If a withholding agent under withholds on a payment under the FDAP withholding rules and then pays additional tax out of its own funds, can the withholding agent seek to recover that additional tax from the payee? According to one commentator in Tax Management 915-2nd, at A-126:

In two cases, Synthetic Patents Co. v. Sutherland,57

and A. Gusmer, Inc. v. McGrath,58 the withholding agent was unable to to recover the additional tax, seemingly on the basis that the withholding agent had neglected the statutory duty of the withhold-ing agent and that no statutory right of recovery was provided. In a third case, McGrath v. Dravo Corp,59the withholding agent debited the foreign

payee’s account for the additional withholding tax and paid the foreign payee the net amount. The Alien Property Custodian sued for the difference between the net amount the withholding agent paid to it and the gross amount prior to the offset for the withholding taxes. The court allowed no recovery because the foreign payee had no right to recover withheld tax amounts from the payor.

The court in these three cases left the parties in the status quo ante. It is likely that a withholding agent will pay additional tax out of its own funds in order to avoid the IRS finding that it is not compliant with the new law and then seek to obtain a refund from the IRS for its payment.60 If a foreign financial institution is not in compliance with its Code Sec. 1471(b) agree-ment because it has erroneously under-withheld, it is possible the IRS may attempt to impose a with-holding tax on the “withholdable payments” made to such institution.” See “Withholdable Payment—In General” and “Credits and Refunds.”

Investor gross-up provisions. In the past, many in-vestors have sought to use gross-up provisions to be contractually protected in the event FDAP withholding tax were to be imposed on an instrument. It is unlikely investors will be able to obtain similar gross-up pro-tection for instruments under the FATCA withholding tax regime (new Code Secs. 1471–1474) because of the more extensive information reporting obligations that will now apply to foreign financial institutions to identify and report the identity of the specified U.S. persons without the benefit of customer certifications (W-8BENs), absent guidance from the IRS to otherwise permit foreign financial institutions to use the existing qualified intermediary KYC or certification rules. See “Elimination of Certification Safe-Harbor.”

Undetermined amounts of income. Tax Man-agement Portfolio 915-2nd, at A-60, provides a discussion if the withholding agent has undetermined amounts of FDAP income:

Withholding is required on payments where the withholding agent does not know at the time of the payment that the amount is subject to withholding either because (i) the source of the income is not determinable at that time or (ii) the calculation of the amount of income subject to tax depends upon facts that are not known at the time of the payment.61The withholding agent must withhold an amount based on the entire amount paid that is necessary to assure that the


July 2010

tax withheld is not less than 30 percent (or an-other applicable percentage) of the amount that will subsequently be determined to be from U.S. sources or to be income subject to withholding tax. The amount of the withholding tax should not exceed 30 percent of the amount paid …62

As an alternative, the withholding agent may make a reasonable estimate of the amount that will be subject to Code Sec. 1441 withholding and place the appropriate tax on that amount in escrow.63 When the amount subject to Code Sec. 1441 withholding is determined, withholding tax is due.

Absent guidance from the Treasury, it would be prudent for withholding agents to withhold on any “withholdable payments” made to foreign financial institutions (FFIs) and nonfinancial foreign entities (NFFEs) where the identity of the U.S. accounts are not determinable and where an exemption from with-holding is not otherwise applicable. It is likely that any amounts overwithheld can be reimbursed by the IRS by filing timely refund claims. See “Credits and Re-funds.” Presumably, the IRS will provide withholding agents with additional guidance in the near future.

Deposit requirements for tax withheld. Under the FDAP withholding rules (e.g., Chapter 3), a withholding agent is required to pay the tax on a quarter-monthly, monthly or annual basis.64 The frequency of deposits depends on the amount of tax withheld. The tax paid must be deposited in a Federal Reserve Bank or a commercial bank authorized to accept remittances of tax for transmittal to a Federal Reserve Bank, with a completed Federal Deposit Form 8109.65

If for any reason the total amount of tax required to be reported on a return for a calendar year has not been deposited in accordance with the requirements,66 the withholding agent must pay the balance at such place as the IRS specifies.67 The tax is required to be paid when filing Form 1042 unless the IRS otherwise requires.68

Foreign currency rules. Under the FDAP withhold-ing rules, the amount of tax withheld that must be paid over to the IRS is that amount of tax withheld at the rate in effect on the date of payment of the income, expressed in U.S. dollars.69 If the amount subject to FDAP withholding tax is payable in foreign currency, the amount of the FDAP withholding tax is determined by applying the applicable rate of withholding to the foreign currency amount and converting the amount withheld into U.S. dollars on the date of payment at

the spot rate as determined under Reg. §1.988-1(d)(1) in effect on that date.70A withholding agent that makes regular or frequent payments in foreign cur-rency may use a month-end or spot rate or a monthly average spot rate.71

Liability for tax even if no tax liability exists. Under the FDAP withholding tax rules, if a with-holding agent cannot reliably associate a payment with documentation or the date of the payment and does not withhold or withholds less than the 30 percent rate required by Code Sec. 1441 (relating to U.S.-source FDAP income), the withholding agent is liable under Code Sec. 1461 for the tax required to be withheld unless an exception applies (e.g., the withholding agent appropriately relied upon a presumption permitted by Treasury, can demonstrate the proper amount was paid or can treat the payment as effectively connected income).72 See “Liability for Withholding Tax, Interest and Penalties.” The regula-tions require that a withholding agent obtain valid, reliable documentation that asserts the status of the beneficial owner prior to making the payment.73 The IRS can impose interest and penalties on a withhold-ing agent if the withholding agent does not have documentation at the time of payment and does not withhold on the basis of presumptions even if no actual underlying tax liability exists.74

Even if a withholding agent becomes insolvent, the insolvent estate remains liable for the tax withheld.75 If several persons qualify as withholding agents with respect to a single payment, tax is required to be withheld only once.76 In practice, generally the last person to have custody or control of the payment prior to the payment leaving the United States with-holds the U.S. tax.77

Withholdable Payments to Foreign Financial InstitutionsThe provision requires a withholding agent to de-duct and withhold a tax equal to 30 percent on any withholdable payment made to a foreign financial institution or its more-than-50-percent–owned finan-cial affiliates if the foreign financial institution does not meet certain requirements.78

Who is the withholding agent? Under the new law, a withholding agent includes all persons, in whatever capacity acting, having the control, receipt, custody, disposal or payment of any withholdable payment.79 This makes every foreign financial institution that en-ters into a Code Sec. 1471(b) or FFI agreement with the Treasury and every withholding agent (that is, a

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U.S. payor to a foreign person) potentially subject to personal liability. See “Withholdable Payments to other Foreign Entities.” Any tax deducted and withheld pur-suant to a Code Sec. 1471(b) agreement will be treated as a tax deducted and withheld by a withholding agent under new Code Sec. 1471(a).80 The JCT Explanation81 expands on the definition of withholding agent for purposes of the new dividend equivalency provisions of the HIRE Act by treating each person that is a party to a contract or other arrangement that provides for the payment of a dividend equivalent as having control of the payment and therefore as a withholding agent.82 See “Substitute Dividends and Dividend Equivalent Payments Received by Foreign Persons Treated as Dividends—New Code Sec. 871.”

Application of Chapter 3 withholding agent rules. For purposes of Chapter 3 of the Code (e.g., withholding tax on nonresident aliens and foreign corporations), the term “withholding agent” means any person, whether U.S. or foreign that has the con-trol, receipt, custody, disposal or payment of an item of income of a foreign person subject to withhold-ing.83 When several persons qualify as withholding agents with respect to a single payment, tax is only required to be withheld once84and generally the last person to have custody or control of the payment immediately prior to the payment leaving the U.S. should withhold the tax.85

The regulations under Code Sec. 1441 address how the definition of “withholding agent” is applied to banks. For example, a foreign bank may have an omnibus account with a U.S. bank, which the foreign bank uses to invest in debt and equity instruments in the U.S. that are subject to FDAP withholding. The foreign bank is a nonqualified intermediary, and both the U.S. bank and foreign bank are withholding agents. The result would be the same if even if the foreign is a qualified intermediary.86

For Chapter 3 withholding tax purposes, if a foreign corporation pays dividends to shareholders who are foreign persons, and if a portion of the dividend is treated as from sources within the United States un-der Code Sec. 861(a)(2)(B) and constitute amounts subject to withholding under Code Sec. 1441, then the dividends are not subject to tax under Code Sec. 884(a) (dealing with the branch profits tax). The for-eign corporation is a withholding agent with respect to these U.S.-source dividends.87

If the IRS interprets the definition of withholding agent under Chapter 4 the same way as it does for Chapter 3, presumably the term will include both

U.S. and foreign persons. Thus, withholding agents will generally include all U.S. and foreign persons (e.g., individuals, partnerships, corporations, trusts, estates, etc.), in whatever capacity they act, who have control, receipt, custody or payment of a with-holdable payment to a foreign financial institution or nonfinancial foreign entity.

For example, if a foreign financial institution, such as a foreign hedge fund, or a non–publicly traded NFFE, such as a privately held foreign corporation, sells stock in another private or publicly traded U.S. corporation, that transaction would be subject to a 30-percent withholding tax under new Code Sec. 1471(a), unless certain reporting and other require-ments are satisfied by the foreign financial institution or the certification or disclosure requirements are met in the case of the non–publicly traded NFFE and the U.S. or foreign payor of the withholdable payment would be the withholding agent.

If the purchaser of the stock uses a brokerage ac-count with a foreign bank to make the acquisition of such stock, and that bank uses a domestic or foreign bank or other qualified or nonqualified intermediary to help close the transaction, these entities will also likely be treated as withholding agents unless the Treasury provides guidance otherwise.

Multiple withholding agents. According to com-ments88 recently submitted by the European Banking Federation and Institute of International Bankers, the Treasury should prescribe regulations that:

… provide clear rules, perhaps illustrated by ex-amples, of common situations where there may be multiple withholding agents potentially required to ensure FATCA compliance. Such examples might address, inter alia, multiple trustees of trusts; invest-ment managers and custodians of securities, as well the various other parties engaged in securities sales, such as the executing broker-dealers, etc. We believe that in such circumstances, the regulations should provide a rule that the withholding agent actually paying a withholdable amount and in the position to perform FATCA withholding should have such obligation, and all other withholding agents are accordingly relieved of the obligation, unless they know or have reason to know that the paying withholding agent will not so comply (or agree otherwise among themselves).

Withholdable payment—in general. With respect to a foreign financial institution, the withholding


July 2010

tax would apply to all “withholdable payments” made to such institution and not just to payments the beneficial owners of which are U.S. persons, including payments received by a foreign financial institution on behalf of one of its clients, although a client generally would be permitted to claim a refund as described below if it would otherwise be entitled to such.89

Determination of the payee or beneficial owner. A withholding agent must deduct and withhold 30 per-cent on any withholdable payment made to a foreign financial institution that does not meet the reporting and certain other requirements under new Code Sec. 1471(a). Similarly, a withholding agent must deduct and withhold a tax equal to 30 percent of any with-holdable payment made to a non–publicly traded nonfinancial foreign entity if the beneficial owner of such payment is such entity or any other nonfinan-cial foreign entity and requirements for certification or disclosure are not met under Code Sec. 1472(a). Under the Chapter 3 withholding regime, a payee is the person to whom a payment is made, regardless of whether the payee is the beneficial owner of the payment.90 If the payment is made to a U.S. agent of a foreign person, the payee will be the foreign person rather than the U.S. agent, and the status of the payee as foreign or U.S. may be determined on the basis of the withholding certificate (e.g., W-8BEN, Form 8233 or Form W-9).91 A payment to a U.S. entity that is wholly owned by a foreign person and that is dis-regarded as a separate owner for U.S. tax purposes under the check-the-box regulations will be treated as a payment to a foreign owner.92 The rule prevents a foreign owner of a U.S. limited liability company from avoiding U.S. withholding taxes under Code Sec. 1441.93 Similarly, under these provisions, part-nerships and other passthrough entities will look to the partner rather than the partnership for purposes of determining the source of the income and the U.S. or foreign status of the payee.94 If a withholding agent makes a payment to a foreign-owned single-member domestic entity, it will be treated as if it was made to a U.S. person.95 Thus, a foreign-owned single-member domestic entity will not be able to claim the benefit of an income tax treaty even if the foreign country in which the entity is organized respects the entity as such under local law.96 The new Chapter 4 withhold-ing regime will require withholdable payments that are made directly to a foreign financial institution or to a non–publicly traded nonfinancial foreign entity to be subject to the new 30-percent tax if the applicable

reporting and other requirements are not met by these entities. The withholding agent will also have a duty to withhold even if the payment relates to another nonparticipating foreign financial institution or is made to the foreign financial institution on behalf of its recalcitrant investors who have failed to provide the required information. Conversely, if the reporting and other requirements are satisfied by the foreign financial institution or the certification or disclosure requirements are met by the nonfinancial foreign en-tity, no withholding tax will be imposed under new Chapter 4, although there may be a U.S. withholding tax imposed under the existing withholding tax regime in Chapter 3. If Chapter 3 principles are applied to the new Chapter 4 withholding regime, presumably the U.S. agent, nominee, broker, clearinghouse or other custodian of such payment who is in the chain of payment will be treated as the withholding agent and not a U.S. person for purposes of such withholdable payments to a foreign financial institution or its clients or to a nonfinancial foreign entity. The fact that the payment is made through a U.S. person will not avoid the imposition of the Chapter 4 withholding tax, which is ultimately made to the foreign financial institution or nonfinancial foreign entity. Similarly, if these same principles are applied to new Chapter 4, a payment made to a wholly owned U.S. entity that is disregarded for U.S. tax purposes should be treated as a payment made directly to the foreign financial institution or its clients, or to a nonfinancial foreign entity.

Beneficial owner/payee status of foreign entities who are disregarded for U.S. tax purposes. It is still an open question how the Treasury will treat foreign enti-ties who are disregarded entities for U.S. tax purposes. Query: Will these entities be treated as separate for-eign financial institutions subject to the reporting rules under new Code Secs. 1471(b)(1)(A) and 1471(c), as well as the requirement under new Code Sec. 1471(b)(1)(D) to withhold on any passthrough payments to a recalcitrant account holder or noncompliant foreign financial institution (unless an election is made be withheld upon for these account holders under new Codes Sec. 1471(b)(3)) or as nonfinancial foreign enti-ties subject to the rules under new Code Sec. 1472(b) to either certify it does not have any substantial United States owners or disclose the U.S. investor information to the withholding agent?

Multiple payees. Similarly, it is undetermined how the Treasury will react if there are multiple payees and foreign transfer agents, such as a foreign investment fund intermediated through independent fund advi-

50


sors, and their transfer agents or custodians who have access to the fund through so-called platforms with both nominee and beneficial accounts who will be treated as the beneficial owner or payee under new Chapter 4 and who has the responsibility to withhold on pass thru payments to recalcitrant holders and noncompliant foreign financial institutions under new Code Sec. 1471(b)(1)(D).

Payments to flow-through entities. A payment made to a foreign partnership or other passthrough entity is treated as a payment made to the foreign partners and is subject to withholding under Chapter 3.97 If a foreign partner is a passthrough entity, the withholding agent must look through the partner until the withholding agent finds a partner that is not a passthrough entity,98 and the foreign partnership is the payee to the extent that the withholding agent can treat the income as effectively connected with the conduct of a U.S. trade or business.99

In the case of intermediaries, a foreign partner-ship or other passthrough entity generally provides a Form W-8IMY, together with a W-8BEN, W-8EXP or a W-8ECI as applicable, furnished by the foreign partner/person who is treated at the payee and ben-eficial owner, unless the intermediary is a qualified intermediary, a withholding foreign partnership or a withholding foreign trust. Thus, Chapter 3 generally takes the position that the determination of the status of the payee is to be made at the partner level.

The issue whether a partnership should be treated as a separate legal entity or as an aggre-gation of its partners has been an issue in U.S. jurisprudence since the enactment of Subchapter K (Partners and Partnerships).

The Treasury must decide if it will treat a foreign partnership or other foreign passthrough entity as the payee or beneficial owner, rather than looking through the entity to the beneficial owner for pur-poses of Chapter 4 withholding. If the withholding agent can reliably associate the payment with a valid withholding certificate or other required documen-tation of the partners or persons, the look-through approach may be the preferable method for this information to be provided to the withholding agent or payors for purposes of determining whether the payment is a “withholdable payment.” Presumably, the partners or beneficial owners of the passthrough entity would then have the right to file U.S. tax returns and claim refunds for the overpayment the tax under U.S. tax law or tax treaties. If an alternative system were to be adopted to make the foreign partner-

ship or other foreign passthrough entity the payee, presumably this entity would have to determine the amount of the U.S.-source income and the amount of the withholdable payment that is allocable to each partner, something that is not now contemplated by current partnership or other governing agreements. As an administrative matter, it would likely also be extremely difficult if not impossible for a foreign partnership or other passthrough entity to file a U.S. tax return and make a claim for refund on behalf of all of its partners if they are otherwise entitled to a refund under U.S. tax law or a treaty.

The U.S. Treasury may also want to provide guid-ance for a U.S. partnership with non-U.S. partners that makes a “withholdable payment” to non-U.S. partners based on each non-U.S. partner’s distributive share of the relevant categories of U.S.-source income or gross proceeds from the sale or U.S. stock or securities. This method is consistent with Reg. §1.1441-5(b).

How does withholding agent get notified of the status of beneficial owner/payee? The Treasury will have to provide guidance on how a Chapter 4 withholding agent identifies whether a payee is the beneficial owner is a foreign financial institution, a nonfinancial foreign financial institution or an exempt payee, subject to an exemption from with-holding because the payee has elected full U.S. 1099 reporting, or the type of entity the Treasury considers to be a low risk of tax evasion. Commentators have suggested that the withholding certificates (e.g., W-8, W-8BEN) could be amended to include the Chapter 4 identification of the payee or beneficial owner and its status under the new rules and provide a copy to the withholding agent so that the withholding agent can determine if it must withhold. An alternative or supplementary approach would be for the payee or beneficial owner to provide this information to the Treasury, which would then post it on its Web site. The author understands that it is likely the Treasury will seriously consider the use of a Web site in the near future. Presumably this Web site will notify the with-holding agents of the status of the beneficial owner or payee as a foreign financial institution, nonfinancial foreign entity or exempt payee as well as provide other relevant withholding information, and may streamline the refund process. While this alternative is desirable from the point of view of the withholding agents who could simply access this Web site, it is likely that a real-time system, which would be necessary to avoid costly mistakes, will be extremely costly and may be difficult to administer. (E.g., What will happen if


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the Web site goes down for periodic maintenance or otherwise, and the withholding agents need the payee or beneficial owner information?)

As was pointed out, withholding agents or payors will withhold from nonparticipating foreign finan-cial institutions who have not satisfied the reporting and other requirements in new Code Sec. 1471 and nonfinancial foreign entities who failed to satisfy the certification or disclosure requirements of new Code Sec. 1472(b) will require notice in a form acceptable to the Treasury (e.g., Form W-8BEN, as amended or its equivalent) and will very likely not accept a contractual representation or other indemnity from these entities as a substitute for the required notice requirements that these entities are compliant so that they themselves don’t incur U.S. withholding tax li-abilities under Chapter 4.

Definition of “withholdable payment.” The term “withholdable payment” under the new law is any payment of interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments and other fixed or determinable annual or periodical (“FDAP income”) gains, profits and income if such payment is from sources within the United States (i.e., payments otherwise subject to nonresident withholding under Code Sec. 871(a)(1)(A) or 881(a)(1) (hereinafter referred to as the “FDAP withholding tax rules”)100 and any gross proceeds from the sale of other disposition of any property of a type that can produce interest or dividends from sources within the United States.101 See “Withholding on Gross Proceeds.”

A withholdable payment would also include port-folio interest and original issue discount (OID) unless the Treasury provides otherwise.102 (See “Portfolio Income/OID Subject to Withholding and Report-ing under the New Law.”) A withholdable payment subject to the 30-percent withholding tax specifi-cally includes any gross proceeds from the sale or other disposition of any property that could produce interest or dividends from sources within the United States.103 See “Withholding on Gross Proceeds.” Under prior law, withholding on gross proceeds was only required if the sale of property being sold was a U.S. real property interest.104

Common types of withholdable payments. Because new Code Sec. 1473(1) defines a “withholdable pay-ment” so broadly, it is possible a withholding agent or payor may have to withhold under new Code Sec. 1471(a) or Code Sec. 1472(a) (if the reporting and other requirements are not satisfied and an exception does not otherwise apply) on U.S.-source interest (without

the exclusion for portfolio interest) and OID, dividends, compensation for personal services, rent, royalties or li-cense fees, prizes or awards, scholarships, pensions and annuities, commissions and fees and gross proceeds from the sale or disposition of U.S. stock or securities may be treated as “withholdable payments.”

The following questions were raised by a one commentator in connection with a nonresident with-holding analysis under Code Sec. 1441. Presumably, many of these same questions should be asked by withholding agents or payors in connection with a FATCA withholding analysis in which the reporting and other requirements are not satisfied by an FFI or non–publicly traded NFFE:

Did the withholding agent or payor pay U.S.-source dividends, interest or royalties to an FFI or non–publicly traded NFFE?Was technology or other property licensed for use in the United States from an FFI or non–publicly traded NFFE? Did the withholding agent or payor make pension payments to an FFI or non–publicly traded NFFE under a U.S. plan?Did the withholding agent or payor make any payments for legal settlements or litigation awards to an FFI or non–publicly traded NFFE?Did the withholding agent or payor pay rent for real property located in the United States to an FFI or non–publicly traded NFFE?Did the withholding agent or payor pay insurance premiums or proceeds from U.S. sources to an FFI or non–publicly traded NFFE?Did the withholding agent or payor pay spon-sorships fees to an FFI or non–publicly traded NFFE?Did the withholding agent or payor have a shared services company that makes payments of any type outlined above to an FFI or non–publicly traded NFFE?Did the payor purchase any private or publicly traded U.S. stock or securities from an FFI or non–publicly traded NFFE?

Similarly, if a U.S. resident alien or green card holder obtains a mortgage from a non-compliant FFI, presumably the U.S resident (and other withholding agents or payors) will have a duty to withhold on the withholdable payments made to the noncompliant FFI which will include the U.S. source interest paid on the mortgage note.

One of the most significant changes made by the new law would be to impose a 30-percent

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withholding tax on any “dividend equivalent payments” (including most equity-based swaps), which will be treated as dividends from sources in the United States.105 See “Substitute Dividends and Dividend Equivalent Payments Received by Foreign Persons Treated as Dividends—New Code Sec. 871.” While the new law’s effective date has been extended to permit time for its implementation to payments beginning September 14, 2010, and has grandfather rules for outstanding obligations on dividend equivalents beginning March 18, 2012, it is possible that, depending on the “gross-up” provisions in an instrument, borrowers may be subject to increased costs or payees may receive less than they originally anticipated. See “Effective Date and Grandfather Treatment for Outstanding Obligations,” and “Effect of the Hire Act on Out-standing Equity Swaps.”

Reduced rates of withholding under tax treaties and items otherwise exempt from U.S. tax. The new law does not permit any relief from withholding at source if the beneficial owner is entitled to an exemption or reduced rate of withholding under an income tax treaty. Similarly, if a withholdable payment represents gross proceeds from the sale of stock or debt, is eligible for the portfolio interest exemption or is not otherwise subject to U.S. tax, there is no relief from withholding at source. Instead, the new law generally permits a beneficial owner of a payment who is entitled under an income tax treaty to a reduced rate of withholding tax on the payment to be eligible for a credit or refund of the excess of the amount withheld over the amount permitted to be withheld under the treaty.106 However, this will require at a minimum that foreign beneficial owners identify themselves and file U.S. tax returns with the IRS and potentially subject themselves to audit and enforcement proceedings against them by the IRS. See “Credit or Re-fund for Reduced Rate of Withholding Under a Treaty” and “New Credit and Refund Mechanism Ensures Resi-dents of Treaty Partners Will Continue to Obtain Treaty Benefits if Tax Is Withheld Under New Law.”

However, where a foreign financial institution is the beneficial owner of such payment credits and refunds, such payments will not be allowed un-less the foreign financial institution is entitled to an exemption or reduced rate of tax by reason of any treaty obligation of the United States. However, in no event will interest be allowed with respect to any credit or refund of tax on such payments. See “Special Rule Where Foreign Financial Institution Is Beneficial Owner of Payment.”

FDAP withholding regime. Certain income re-ceived by foreign persons is subject to United States gross basis taxation. The income must be fixed, determinable, annual or periodic (FDAP), must be U.S. sourced and must not be included in the foreign person’s gross income as effectively connected with any U.S. trade or business of that person (ECI). If these conditions are met, the income will generally be subject to the withholding rate under Code Sec. 1441 or 1442 (generally 30 percent).107

The withholding rate can be reduced or eliminated based on an applicable treaty or Code section, such as the portfolio interest exception.108 Code Secs. 1441–1443 and 1461 set forth when and how the tax is withheld and reported. Withholding and reporting may instead be required under Code Sec. 1445 with respect to dispositions of U.S. real property interests and under Code Sec. 1446 with respect to foreign partners’ allocations of ECI from partnerships.

FDAP source rules applicable to new law. Pre-sumably, the U.S. source rules applicable to FDAP withholding tax will continue to apply to with-holdable payments under the new law with certain exceptions (see “Special Rule for Sourcing Interest Paid by Foreign Branches of Domestic Financial Institutions”), unless the Treasury provides guidance otherwise. Under the FDAP withholding tax rules, “FDAP income” includes all items of gross income, except gains on sales of property (including market discount on bonds and option premiums) and insur-ance premiums paid to a foreign insurer or reinsurer.109

Thus, under the FDAP withholding tax rules, interest is derived from U.S. sources if it is paid by the United States or any agency or instrumentality thereof, a state or any political subdivision thereof, or the District of Columbia. Interest is also from U.S. sources if it is paid by a resident or domestic corporation on a bond, note or other interest-bearing obligation.110 Dividend income is sourced by reference to the payor’s place of incorporation.111 Thus, dividends paid by a do-mestic corporation are generally treated as entirely U.S.-source income. Similarly, dividends paid by a foreign corporation are generally treated as entirely foreign-source income. Rental income is sourced by reference to the location or place of use of the leased property.112 The nationality or the country of residence of the lessor or lessee does not affect the source of rental income. Rental income from property located or used in the United States (or from any interest in such property) is U.S.-source income, regardless of whether the property is real or personal, intangible


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or intangible. Royalties are sourced in the place of use (or the privilege of use) of the property for which the royalties are paid.113 The source rule applies to royalties for the use of either tangible or intangible property, including patents, copyrights, secret pro-cesses, formulas, goodwill, trademarks, trade names and franchises.114

Special rule for sourcing interest paid by foreign branches of domestic financial institutions. Under the FDAP withholding tax rules interest on deposits with foreign branches of domestic banks and do-mestic savings and loan associations is not treated as U.S.-source income and is thus exempt from U.S. FDAP withholding tax (regardless of whether the recipient is a U.S. or foreign person).115 In addition, under the FDAP withholding tax rules, interest on bank deposits with domestic savings and loan as-sociations and certain amounts held by insurance companies are not subject to the U.S. withholding tax when paid to a foreign person unless the interest is effectively connected with a U.S. trade or business of the recipient.116 Similarly, interest and original issue discount on certain short-term obligations is also exempt from U.S. withholding tax when paid to a foreign person under the FDAP withholding tax rules.117 Consequently, under the FDAP withholding tax rules there is generally no information reporting with respect to payments of such amounts.118

In contrast, under the new law in determining the source of a payment, Code Sec. 861(a)(1)(B), the rule for sourcing interest paid by foreign branches of domestic financial institutions will not apply.119 Presumably, this provision was put into the new law to ensure that these entities will be compelled to enter into 1471(b) agreements and provide information reporting and satisfy the other requirements the IRS may prescribe to avoid withholding tax as a “with-holdable payment” under the new law. See “General Requirements to Avoid Withholding.”

Foreign-source income. It should be pointed out that investments paying income from foreign sources will not be subject to the new law requiring withhold-ing if the reporting and other requirements of a Code Sec. 1471(b) agreement are not otherwise satisfied. See “General Requirements to Avoid Withholding.” However, without the inclusion of such income in the new regime, commentators have suggested that it may still be possible for U.S. taxpayers to structure their investments in such a manner so as to avoid the withholding and reporting requirements of the new law entirely, absent the prescription of anti-abuse

rule (presumably with examples of the kind of abuse Treasury is targeting.)

For example, if a private equity, hedge fund or other investment fund or vehicle is set up in the Cayman Islands for investors, which only has foreign stock and securities as its only investments, will the new regime apply to this fund and its investors? Assuming that an anti-abuse rule is not otherwise applicable and the only income generated from the fund is foreign source income, one would think the answer would be no. However, if the foreign managing member or the promoter of the fund is itself subject to the new regime as a foreign financial institution or is a mem-ber of an “expanded affiliated group” that has made separate proprietary investments (or investments on behalf of it’s clients) that generate “withholdable pay-ments,” such as U.S. source FDAP income or gross proceeds from the sale or disposition of any property that could produce interest or dividends from sources within the United States, then it is possible for the fund and its U.S. investors to be brought into the reporting and withholding requirements of Chapter 4. See “New Code Sec. 1471 Applies to Expanded Affiliated Group.”

ABA Tax Section Comments on investments paying foreign-source income. The ABA Tax Section Com-ments on the proposed FATCA legislation provided comments on the issue by stating:120

We note that the Bill would create an incentive for U.S. and foreign investors wishing to avoid compliance to shift investments to FFIs that themselves have no withholdable payments from the United States to avoid the new reporting and withholding tax regime. Doing so would not require foregoing exposure to U.S. dollar invest-ments. For example, such investors could buy U.S. dollar denominated instruments of such FFI paying foreign source income. Of perhaps greater concern, the Bill would not address the case in which an FFI makes debt or equity investments in a second FFI (a corporation for U.S. tax purposes) that is invested in U.S. securities. Similarly, an FFE might invest in a corporate FFI with U.S. invest-ments. The instruments held by the first FFI and the NFFE would generate foreign source income and thus not result in withholdable payments. In extreme cases, the arrangement could amount to a conduit arrangement. A similar issue arises when a custodial account holds principally or only foreign securities. From one standpoint it

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would be helpful if withholding could be im-posed on foreign source income payable to a noncompliant party. This would be preferable to requiring that an FFI self-withhold as it would provide incentive on the investor or account holder to comply and would place the monetary burden of the withholding where it should be. The withholding “tax” would be in the nature of a penalty for failure to provide information rather than an income tax. We are, however, doubtful that such a mechanism could be achieved com-mercially and that an FFI could or would agree to it.121 Further, any such approach would raise significant issues under our tax treaties. We be-lieve that Treasury has existing authority under Code Sec. 7701(I)122 to address abusive cases of a conduit nature. We recommend that the infor-mation reporting required under section 101 of the Bill should include reporting in respect of any potential conduit arrangement of which the reporting entity is aware.

Portfolio income/OID subject to withholding and reporting under the new law. Since 1984, the United States has not imposed withholding tax on portfolio interest received by a nonresident indi-vidual or foreign corporation from sources within the United States.123Portfolio interest includes generally any interest (including original issue discount) other than interest received by a 10-percent shareholder,124

certain contingent interest,125interest received by a controlled foreign corporation or from a related per-son126 and interest received by a bank on an extension of credit made pursuant to a loan agreement entered into in the ordinary course of its trade or business.127 The new withholding and reporting tax regime will apply to portfolio interest, which is exempt under the FDAP withholding tax rules, unless the Treasury pro-vides prescribes guidance otherwise. See “Treasury Permitted to Prescribe Exceptions to the Definition of “Withholdable Payment.”

ABA Tax Section Comments regarding portfolio interest and OID. The ABA Tax Section Comments commented on this issue and stated:128 “This provi-sion would therefore overrule Code Secs. 871 and 881 with respect to, for example portfolio interest and would be akin to an excise tax to the extent imposed on a return of invested capital or the receipt of OID accrued prior to the owner’s holding period.” The ABA Tax Section Comments also suggested that the amount of OID inclusion would be broader then in found in

the “normal” nonresident withholding provisions by stating:129 ”Thus, unlike Code Secs. 871(a)(1)(C) and 881(a)(3), withholding on OID would appear to apply to the entire amount of OID accrued through the date of payment and would not be limited to the amount ac-crued while the instrument was held by the payee.”

Withholding on gross proceeds. Under the FDAP withholding tax rules, gains derived from the sale of property by a nonresident alien individual or foreign corporation are exempt from the U.S. withholding tax rules and are generally not subject to any U.S. tax unless they are effectively connected with the conduct of a U.S. trade or business. Gains derived by a nonresident alien individually generally are subject to U.S. taxation only if the individual is pres-ent in the United States for 183 days or more during the taxable year.130 Foreign corporations are subject to tax with respect to certain gains on disposal of timber, coal or domestic iron ore and certain gains from contingent payments made in connection with sales or exchanges of patents, copyrights, goodwill, trademarks and similar intangible property.131 Most capital gains realized by foreign investors on the sale of portfolio investment securities thus are exempt under the FDAP withholding tax rules.

Importantly, the new law changes this result for withholdable payments and specifically includes any gross proceeds from the sale or other disposition of any property that could produce interest or dividends from sources within the United States (even in situa-tions in which there is no inherent gain),132 including dividend equivalent payments treated as dividends from sources in the United States pursuant to Sec-tion 541 of the new law in the new withholding and reporting rules.133 The new law clarifies the proposed FATCA provision by specifically providing that gross proceeds from nonsale dispositions from property that can give rise to U.S.-source interest or dividends will be a “withholdable payment.” One commentator sug-gested the Treasury should limit the total withholding tax obligation to the maximum amount held in the financial account. If the withholding tax is based on withholding on the gross proceeds from the sale or disposition of any property that could produce interest or dividends from sources within the United States, it is entirely possible that the amount withheld could exceed the maximum amount invested in the financial account. At lease one commentator has raised the is-sue that because new Code Sec. 1473(1)(A)(ii) makes reference to the sale or disposition of any property of a type that can produce interest or dividends that a sale


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of disposition or property that produces capital gains rather than interest or dividends may not be includable as a “withholdable payment.” The Treasury may want to provide clarification on this on this point.

Staff of the Joint Committee on Taxation gross proceeds compliance and administrative con-cerns—President’s budget proposals. The Staff of the Joint Committee on Taxation had the following comments with respect to a President’s Fiscal Year 2010 Budget Proposal, one of the predecessor leg-islative proposals regarding considerations relating to gross proceeds withholding:134

U.S. law and U.S. tax treaties generally treat gains as taxable only in the country of the taxpayer’s residence, unless the gains are connected with a trade or business or are gains related to real prop-erty. The proposal does not change the sourcing or taxation of gains earned by foreign persons and paid through nonqualified intermediaries, but it would impose withholding tax on the gross proceeds from certain sales of securities. As a consequence, however, the proposal can be ex-pected to result in substantial over-withholding. Implementation of an efficient refund procedure may mitigate the effects of over-withholding to some degree; in many cases, however, the amount of tax withheld may substantially exceed the gain (if any) realized by the investor on the transaction, so that any delay in receiving the full amount of sales proceeds could have a punitive effect. The proposal may, therefore, create an incentive for foreign investors to conduct U.S. securities sales transactions through financial institutions that are not U.S. withholding agents (i.e., a foreign broker sells the security directly in an overseas market, which does not trigger gross proceeds withholding because it does not involve a U.S. withholding agent.” See “ABA Tax Section Comments on Investments Paying Foreign Source Income.

ABA Tax Section Comments on gross proceeds withholding. The ABA Tax Section Comments ad-dressed the imposition of withholding on gross proceeds for the FATCA proposed legislation by stating:135 “The risk of withholding on gross proceeds raises the stakes of being wrong to a very consider-able extent, such that numerous entities may decline to participate and instead opt out of U.S. securities. Given withholding on income, it might be asked

again whether gross proceeds withholding, at least at a 30 percent rate, is a necessary ‘stick.’ Although it is conceivable that an account may be invested nearly entirely in nondividend paying stocks, we think that it is unlikely and an insufficient reason to view gross proceeds withholding as necessary to enforce compliance.”

Exception for income connected with U.S. busi-ness. Unlike the FATCA proposed legislation (but similar to the FDAP withholding tax rules), the new law provides any item of income effectively connected with the conduct of a trade or business within the United States that is taken into account under Code Sec. 871(b)(1)136 or 882(a)(2)137 will not be treated as a withholdable payment for purposes of the new law. 138 Thus, payments to a foreign financial institution’s U.S. branch will typically not be subject to the reporting and withholding tax regime.

In general, various U.S. tax treaties exempt income effectively connected from a U.S. trade or business unless such income is attributable to a permanent establishment. As a general rule, a statute or law enacted after a tax treaty will not change the provi-sions of a tax treaty unless Congress clearly expresses its intent to modify the tax treaty. Neither the statute nor the legislative history addresses whether income effectively connected with a U.S. trade or business must be subject to U.S. tax in order to be exempt from the definition of withholdable payment under new Code Sec. 1473(1)(B).

It is presently unclear under new Code Sec. 1473(1)(B) how the Treasury will interpret the meaning of the phrase “taken into account.” For example, if the Treasury interprets this phrase narrowly, must a foreign financial institution or nonfinancial foreign entity be subject to U.S. taxation and to file a U.S. tax return (e.g., Form 1120F) and report the income that is effectively connected to the conduct of a trade or business within the United States, or will the Treasury permit an exception from withholding even if the such U.S. income tax returns are not timely filed or exemption otherwise applies to such income139 under a tax treaty or U.S. tax law? Query, how will a withholding agent or payor know if an item of income is effectively connected with a U.S. trade or business? Presumably, the foreign financial institution or nonfinancial foreign entity will provide the withholding agent or payer with a W-8ECI, as amended or it equivalent.

Treasury permitted to prescribe exceptions to the definition of “withholdable payment.” In an important

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new provision from the proposed FATCA legislation, the new law permits the Treasury to prescribe excep-tions to the term “withholdable payment.”140 Under Code Sec. 871(g)(1)(B)(i), withholding is not required under Chapter 3 in respect of original issued discount on obligations with a term of 183 days or less if the instrument was held by a non-U.S. person. The leg-islative history directs that the Treasury may provide guidance and determine that certain payments made with respect to short-term debt or short-term deposits, including gross proceeds paid, which may pose little risk of tax evasion and may be excluded from the term “withholdable payments.”

Query, if the Treasury excludes certain “short-term debt” from the definition of “withholdable payment,” will notes that are structured as a series of renewable short-term notes with otherwise identical terms to a mid-term or long-term debt instrument be exempt, and will notes that, by their terms, are payable on demand also be exempt? However, the Treasury may want to exempt original issue discount on certain short-term obligations by applying the principles in Reg. §1.1272-1(f)(2), which generally provides that the maturity date of a debt instrument is the last pos-sible date that the instrument could be outstanding under the terms of the instrument. Unfortunately, the legislative history does not expand upon what par-ticular payments it would like the Treasury to except from the new withholding regime or whether docu-mentation and verification of such payments would nonetheless continue to be required to be provided by foreign financial institutions to be compliant.

It should be noted a nonresident alien individual or foreign corporation is subject to a tax equal to four percent of such individual’s or corporation’s U.S.-source gross transportation income under Code Sec. 887 and is not taxable under Code Secs. 871, 881 or 882. Since this income is subject to its own reporting requirement, the Treasury may want to consider carving out an exemption under FATCA for this income as well.

The EBF/IIB Comments141 advocated excluding some payment types from the definition of “with-holdable payment” by providing:

The EBF and IIB strongly support this approach and recommend that the following payments should be excluded given their corresponding exclusion from Chapter 3 withholding under Treasury Regulation Section 1.1441-2(a). In-cluding these payments for FATCA withholding,

but not Chapter 3 withholding presents serious operational and automated system difficulties that should not be underestimated: (1) short-term interest and original issue discount (“OID”); (2) payments under short-term securities sale-and-re-purchase (repo) or securities lending agreements, whether or not such payments are OID; (3) certain derivative payments; (4) OID paid on the sale of an obligation other than a redemption; (5) interest accrued on an obligation sold between payment dates; and (6) market discount. We also believe that inter-financial institution transactions (and payments relating thereto) should be excluded. We also believe that those payments that con-stitute miscellaneous FDAP not related to U.S. securities (e.g., fees for services, rent, royalties, etc.) should be carved out of the definition of withholdable payments. It appears that FATCA was meant to target offshore U.S. accounts and it makes sense to accordingly limit the kinds of payments subject to FATCA withholding to those associated with U.S. bank deposits or securities. Moreover, such miscellaneous FDAP payments are typically not necessarily made by withhold-ing agents that are financial institutions or by the divisions of financial institutions that are charged with FATCA compliance, and it will be very bur-densome to require them to set up the systems to handle such compliance.

SIFMA Comments recommending limiting the definition of “withholdable payment.” The SIFMA Comments to the proposed FATCA legislation rec-ommended limiting the definition of “withholdable payment” by stating:142

The definition of withholdable payment is extreme-ly broad, and appears to include many items that pose a very low risk of facilitating U.S. tax evasion (including, e.g., payments for services performed in the United States; adjustments required under Code Sec. 482; issuances of stock in tax-free reor-ganizations; and intercompany payments between a U.S. company and a foreign affiliate). Although the FE information reporting and withholding re-gime provides for a mechanism for the Secretary of the Treasury to exclude certain payments from the withholding tax, the FFI information reporting and withholding regime does not contain a similar payment based carve-out mechanism.143SIFMA recommends that [FATCA] authorize the Secretary


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of the Treasury to exclude from the entire definition of withholdable payment any payments that pose a low risk of tax evasion, and that the Treasury Department and the IRS be directed to consider the exclusion of the above-noted payments (and others) under this authority.

General requirements to avoid withholding. With-holding on any “withholdable payment” made to a foreign financial institution or its financial affiliates is not required if a Code Sec. 1471(b) agreement is in effect between the foreign financial institution and the Treasury, which the institution agrees to the following six requirements:144

1. Obtain such information regarding each holder of each account maintained by the institution as is necessary to determine which accounts are U.S. accounts.145

2. Report annually information required by new Code Sec. 1471(c) with respect to any U.S. ac-count maintained by such institution.146

3. Comply with such verification and due diligence procedures as the Treasury may require respect to the identification of U.S. accounts.147

4. Comply with requests by the Secretary for ad-ditional information with respect to any U.S. account maintained by such institution.148

5. Attempt to obtain a valid and effective waiver in any case in which any foreign law would (but for a waiver) prevent the reporting of information required by Code Sec. 1471(c) with respect to any U.S. account maintained by such institution, and if a waiver is not obtained from each account holder within a reasonable period of time, to close the account.149

6. Deduct and withhold 30 percent from any “passthrough payment” that is made to a (a) “re-calcitrant account holder,” (b) foreign financial institution that does not enter into a Code Sec. 1471(b) agreement with the Treasury (a “non-participating foreign financial institution”), or (c) foreign financial institution that has elected to be withheld upon, rather than to withhold with respect to the portion of the payment that is allocable to a recalcitrant account holder or nonparticipating foreign institution.150

Code Sec. 1471(b) agreement—foreign finan-cial institution implementation issues. The EBF/IIB Comments151 recommended that the FFI agreement process be as simple as possible and more stream-lined with the following comment:

The FFI agreement process should be made as simple as possible given the potential volumes involved, … . The FFI agreement process should be substantially simpler and more streamlined than the QIA application process. In particular, the process should be self-implementing. That is, a non-U.S. financial institution would simply file a form electronically with the IRS whereby it agreed to undertake the FFI obligations, and provide an explicit release to the IRS to publish its name as a participating FFI. We believe that it would be sensible for the IRS to issue a list of participating FFI taxpayer identification numbers (“TIN”), as it did for QIs, and publish those TINs along with the FFI’s name so that a withholding agent is better able to match the information on the IRS list against the information in its systems. For QIs, the EBF and IIB believe that FATCA intends the process to be even simpler. A QI would be deemed a participating FFI and subject to those obligations unless it chose otherwise. Again, QIs opting to be a nonparticipating FFI should have a simple way of doing so. We believe that the election itself should function as the “FFI Agreement” and there should be no need for a separate agreement similar to the QI Agreement. The tasks in Code Sec. 1471 lend themselves to a series of discrete certifications as to what the FFI will do in order to be considered compliant. We would suggest that the IRS create a format for an FFI to make these certifications as part of its election to be a participating FFI. In other words, the tasks specified in Code Sec. 1471(b)(1) could be reduced to a series of certifications to ensure that the FFI understands what it is agreeing to do for the IRS (e.g., FFI certifies that it will (1) obtain information regarding each holder of each ac-count as is necessary to determine which if any such accounts are U.S. accounts; (2) comply with applicable verification and due diligence standards relating to such accounts (which must be clearly and publicly detailed in advance of such election being made); etc.). We suggest this approach because the QIA has proven to be a disincentive for an institution to opt for QI status given that it is a highly legalistic document with numerous cross references to the Treasury regulations. We believe that Treasury and the IRS should avoid this problem in the FFI context to avoid as many disincentives to participating FFI status as possible.

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Code Sec. 1471(b) requirements. The first require-ment obligates the foreign financial institution to obtain such information regarding each holder of each account maintained by the institution as is nec-essary to determine which accounts, if any, are “U.S. accounts” (see “U.S. Account and U.S.-Owned For-eign Entity”) and the second requirement mandates that it annually report the information required by new Code Sec. 1471(c) with respect to any U.S. ac-count maintained by such institution to the Treasury. (See “Annual Reporting for Foreign Financial Institu-tions.”) The third requirement obligates the foreign financial institution to comply with such verification and due diligence procedures as the Treasury may require respect to the identification of U.S. accounts. As a practical matter, it is likely that most foreign fi-nancial institutions will require their depository and custodial account holders and the holders of non–publicly traded debt or equity of the foreign financial institution to certify whether they are a “specified U.S. person” or “U.S.-owned foreign entity,” and to provide the required information if they are such persons or entities. Presumably, the Treasury, with the assistance of industry, will develop an acceptable “certification” process and will take into account the difference in resources available by smaller foreign financial institutions and smaller investment vehicles, and, according to the JCT Explanation, the Treasury may use existing know-your-customer, anti–money laundering, anti-corruption and other regulatory requirements as the basis for designing the new due diligence and verification procedures and processes to be Code Sec. 1471(b) compliant. See “Clarify Stan-dards for Determining U.S. Status of Accounts” and “Due Diligence and Verification by Foreign Financial Institutions.” The Treasury may want to consider us-ing a less formal Code Sec. 1471(b) agreement (e.g., short form, self-executing electronic submission) for smaller foreign financial institutions and for those foreign financial institutions located in jurisdictions with a tax treaty with the United States that has an information-sharing provision. In such cases, the op-portunities for tax evasion may be reduced.

Consolidated FFI election and consolidated annual report. It is presently unclear whether the Treasury will permit the Code Sec. 1471(b) agreement to be drafted in short form, self-executing and submitted electronically in appropriate cases; whether the it will permit a foreign financial institution to enter into a consolidated Code Sec. 1471(b) agreement for its global business including those entities in

its expanded affiliated group (see “New Code Sec. 1471 Applies to ‘Expanded Affiliated Group”); or whether there will be flexibility to permit multiple Code Sec. 1471(b) agreements for a foreign finan-cial institution’s separate lines of business, such as the broker-dealer business, which typically is highly regulated, and the proprietary trading or wealth man-agement businesses, which may have confidentiality concerns regarding client U.S. account disclosures between each competing business. Whether or not a Code Sec. 1471(b) agreement is entered into with the Treasury on a consolidated basis for a foreign financial institution and its members that are a part of its “expanded affiliated group” as defined under new Code Sec. 1471(e), who have U.S. accounts or whether such entities enter into separate Code Sec. 1471(b) agreements, it is important that the Treasury provide guidance on the extent of withholding tax liability each member is undertaking. For example, is the withholding tax liability for passthrough payments to recalcitrant account holders and non-compliant FFIs under new Code Sec. 1471(b)(1)(d) a joint and several liability of the FFI and each member of the expanded affiliated group with U.S. accounts (assum-ing another exemption does not otherwise apply), and if one of the members is sold in a taxable sale or nontaxable transaction, will the buyer or acquir-ing party inherit any unpaid Code Sec. 1471(b)(1)(d) and other Chapter 4 liabilities for the remaining FFI and the other members in the expanded affiliated group with U.S. accounts? Does it matter if they are a party to a consolidated Code Sec. 1471(b) agree-ment or have entered into separate agreements with the Treasury? The EBF/IIB Comments152 also raised the consolidation issue by providing:

We recommend that (1) an electing FFI should be able to specify at the time of its election whether the election extends to other members of its worldwide affiliated group, and (2) to the extent specified by the FFI, this election extend to any entities formed, controlled or sponsored by the FFI (such as investment funds or special purpose vehicles). If an FFI indicates that it will file a con-solidated FFI annual report on behalf of its group, then all members of the FFI’s worldwide group would be presumed covered unless the FFI speci-fies which entities or categories of entities it does not intend to cover in its reports. The FFI would be responsible for ensuring that information on U.S. accounts held by those entities not so carved out


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are a part of its consolidated annual report. The guidance should also permit various entities, divi-sions or locations within the affiliated group to file separate annual reports and should not require the consolidation of information that is gathered from separate data systems onto a single report. We fur-ther recommend that as part of a consolidated FFI annual report the FFI be allowed to specify which of its related affiliates and entities: (1) satisfy one of the explicit exceptions to FFI status; (2) have no U.S. accounts and thus fall under the exception in [Code] Code Sec. 1471(b)(2)(A)(i); or (3) satisfy the criteria to be an FFE. In that way, a worldwide fi-nancial group could rationalize the many different FATCA requirements into one election and report-ing requirement. We also believe that this allows such a worldwide group the flexibility to carve out those affiliates that themselves wish to become participating FFIs.” In testimony submitted by Tom Prevost, the Americas Tax Director for Credit Suisse to the House Ways and Means Subcommittee on Select Revenue Measures on November 5, 2009 comments were provided about certain open is-sues which need to be addressed before a foreign financial institution can comply with the new requirements including:153

Release by the IRS of the standard FFI Agree-ment, new and revised certification forms and new FFI information reporting forms. In revising existing certification forms such as IRS Form W-8s, it would be helpful if the IRS could simplify the current form require-ments to ease the confusion and potential errors caused by their complexity. We would be happy to provide the IRS with a list of concerns relating to the existing Form W-8s to be considered by the IRS when designing new forms.Whether FFI information reporting must be done on aggregate basis for each account, or with respect to each substantial US owner’s share thereof. We believe the Bill requires reporting to be done on an aggregate basis, rather than based on each U.S. owner’s share of the account. As there are a number of additional complexities with significant ad-ditional costs that arise if FFIs are required to do the reporting on a segregated basis, con-firmation of the aggregate approach would be helpful.

Due Diligence Procedures. Not only in the case of U.S. owners of foreign entities, but for all account holders, whether FFIs will be required to do any additional due diligence beyond their existing know-your-customer/anti–money laundering procedures.Change in Status. In the case of U.S. owners of foreign entities, how changes in the status of U.S. persons as substantial U.S. owners (both year-to-year and within each year) are handled, and the frequency with which such information is to be updated by the FFI.154

We note that the 2011 effective date [“see Effective Date and Grandfather Treatment for Outstanding Obligations”] coincides with the effective date for cost basis reporting, the im-plementation for which financial institutions will have over three years to prepare for.

European Banking Federation Comments—FFI agreements with the IRS. The European Banking Federation and the Institute of International Bankers (collectively, “EBF”) submitted comments to the U.S. House Ways and Means Committee on the proposed FATCA legislation (hereinafter referred to as “EBF FATCA Comments”), which raised concerns that it is possible that a two-tier system may be created by the new law with the following commentary:155

Recommendation. The legislative history should clarify that Congress expects that the Treasury Department will issue guidance exempting cat-egories or classes of FFIs from the requirement that they enter into FFI agreements with the IRS provided that such FFIs either comply with the requirements of proposed Section 1472 or pres-ent a sufficiently low risk of tax evasion that they should be totally exempted from the new Chapter 4 rules.

Rationale. Proposed Code Sec. 1471(b) would require the approximately 5,500 financial in-stitutions that currently are QIs, as well as the several tens of thousands of financial institutions that are eligible to become QIs but have not done so (i.e., NQIs), to enter into agreements with the IRS. In addition, hundreds of thousands of foreign investment entities—including hedge funds, private equity funds, mutual funds, secu-ritization vehicles and other investment funds (whether publicly held or privately owned, and even if they have only a handful or fewer

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investors)—would be required to enter into agreements with the IRS.

While the precise responsibilities of an FFI under an FFI agreement are unclear at this time, at a minimum an FFI would need to set up identification, reporting and withholding systems and procedures covering virtually ev-ery business line around the world, and may be subject to outside verification obligations. Even existing QIs (few of whom have today assumed primary withholding responsibility) would need to revise their systems to address potential withholding tax on gross sales proceeds from U.S. securities, which requires a transaction-based architecture that is completely different from the systems that have been developed to capture information regarding U.S.-source interest, dividends and other FDAP income. The enormity of this task—both for individual FFIs and across the financial and investment industries—cannot be overstated, nor can the risk of a broad application of the new 30-per-cent withholding tax on withholdable amounts, with potentially disruptive effects on the U.S. capital market.

We would expect that most large international banks that are QIs and that have substantial U.S. operations, as well as large investment fund groups with significant U.S. investments, will enter into FFI agreements and make every effort to comply with these new requirements, despite the significant costs. We are very concerned, however, that many other QIs, NQIs and foreign investment entities will not be able and/or willing to enter into such agreements, either because of the costs and burdens of compliance, as well as the exposures from an inability to comply, or—especially in the case of smaller FFIs—because of a concern about entering into an agreement with a distant tax authority.

If, as we fear, more than an insubstantial number of FFIs do not enter into FFI agreements with the IRS, there is a risk of considerable shifts in capital flows, as many FFIs (including possibly some large institutions) move investments from the United States in order to avoid the withhold-ing tax while investors that wish to continue to invest in the United States move their investments

to qualifying FFIs.156 We are not in a position to quantify the potential extent of any disinvestment from the United States or other market disrup-tions, but we urge Congress and the Treasury to carefully evaluate these risks. In this regard, we note that these adverse results, were they to oc-cur, would be very detrimental to the business of international financial institutions, and thus our memberships share a strong common inter-est with the U.S. government in ensuring that the new rules do not produce material adverse consequences to financial markets and capital flows (in addition to our common commitment to combat tax evasion).

Moreover, we are concerned that if more than an insubstantial number of FFIs do not “buy into” the new regime, a two-tier financial system will emerge, in which some financial institutions that are nonqualifying FFIs may become a haven for U.S. tax evaders.

In our experience, a very high percentage of NQIs are fully compliant with the existing reporting rules. These institutions have not become QIs not because they wish to facilitate U.S. tax evasion but, rather, because their U.S. investment base is too small to justify the costs and burdens of being QIs. We would expect that these NQIs would be prepared to comply with expanded requirements that they identify their direct U.S. account hold-ers as well as the substantial U.S. owners of their account holder entities, if these requirements are properly and reasonably designed.

As noted elsewhere in this letter, developing a workable system for identifying substantial U.S. owners is itself a very challenging task, particu-larly given that there are often multiple tiers of FFIs. However, we would expect that FFIs will more readily be able to obtain the necessary U.S. tax-specific information regarding substantial U.S. owners from account holder entities that are investing in material amounts of U.S. securities, whereas in the case of account holder entities that are invested in non-U.S. accounts and securities, the FFIs will necessarily need to rely on informa-tion that is already in their databases.157

We have no experiential basis to be able to determine whether foreign investment entities


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that are unable or unwilling to enter into FFI agreements would nonetheless be able and willing to comply with a Code Sec. 1472–type reporting regime. However, based on the fact that many NQIs and partnerships do comply with the requirements under existing law that they obtain and pass on certifications from their account holders and beneficial owners, there is reason to believe that many such foreign invest-ment entities would be prepared to comply with expanded requirements that they determine substantial U.S. owners of their account holder entities, if these requirements are properly and reasonably designed (as discussed above). In any event, we believe that a significantly higher percentage of such foreign investment entities will be able to comply with the rules (and will therefore remain invested in U.S. securities) if they are given the choice of a Code Sec. 1471 or 1472 regime (which is similar to the choice that financial institutions have today to either become a QI or to report under the NQI rules) than if they are forced to enter into FFI agree-ments in order to avoid withholding tax.158

We also stand ready to work with the Treasury and the IRS to identify those foreign entities that should be exempted from both the proposed Code Sec. 1471 and 1472 requirements on the basis that they do not present the United States with a substantial risk of tax evasion activity.

NYSBA Tax Section Comments—Concerns regarding “one-size-fits-all” Code Sec. 1471(b) agreements. The NYSBA Tax Section picked up on this issue by stating:159

The legislation seems to contemplate a one-size-fits-all Code Sec. 1471(b) agreement for all foreign financial entities, notwithstanding the diverse types of entities covered by the rules. The Code Sec. 1471(b) agreements should be sensitive to the type of financial entity to which it applies and the environment in which it operates. The definition of a “foreign financial institution” covers entities as different as global universal banks, large mutual funds held by numerous investors, special purpose securitization vehicles and small family investment companies. It covers institutions operating in sophisticated financial centers and developing economies; in countries

with internal reporting systems designed to pre-vent tax evasion and/or money-laundering and countries without such systems; in jurisdictions where information sharing is routine and others where it is problematic; in countries that are close allies of the United States and countries that are not. The Treasury Department should have explic-it authority to take these differences into account in drafting Code Sec. 1471(b) agreements.

The Treasury Department should also be authorized to coordinate implementation of these agreements with local banking and securities regulators and tax authorities, through the competent author-ity provisions of tax treaties and tax information exchange agreements and through international organizations. In particular, the Treasury Depart-ment should be authorized to share information collected through the Code Sec. 1471 process and the regular information reporting systems (including information collected on Form 1042 and 1042-S) with foreign jurisdictions as part of the process of encouraging non-U.S. tax administrators to cooper-ate with the information gathering requirements of Code Secs. 1471 and 1472. The system will not op-erate properly if financially significant jurisdictions find that the information collection and reporting required by Code Sec. 1471 violates their consumer data protection or bank secrecy laws.

Elimination of certification safe harbor. In a noteworthy change from the FATCA legislation, the HIRE Act does not have any safe harbor for a foreign financial institution to rely upon a certification made by an account holder as to whether the account is a U.S. account. Under FATCA, a foreign financial institution could rely on the certification from an account holder as to whether an account is a U.S. account, and with respect to the name, address and TIN of each specified U.S. person and substantial U.S. owner, provided neither the foreign financial institution nor any entity that is a member of the same expanded affiliated group as the foreign financial institution knows, or has reason to know, that any information provided by the account holder in the certification was incorrect.160 The likely impact of not having such a certification safe harbor will be for foreign financial institutions to be compelled to develop resource-intensive diligence and verification processes to ascertain whether the accounts are U.S. accounts. To that end, the IRS may mandate exten-

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sive new internal procedures as well as independent review procedures to ensure compliance.

SIFMA Comments on the need for workable pro-cedures for reliance on certifications by foreign financial institutions. While the certification safe harbor has been now been eliminated under the new law, SIFMA raised meaningful concerns that still need to be addressed about how the new Code Sec. 1471(b) agreements will be implemented by foreign financial institutions by stating:161

The Bill provides that, in fulfilling its information reporting obligations, an FFI may rely upon a cer-tification from an account holder only if neither the FFI nor any entity which is a member of the same expanded affiliated group knows, or has reason to know, that any information provided in such certification is incorrect. The expanded affiliated group of a large FFI many include tens of thousands of employees in hundreds of dif-ferent branches, business entities and segments, located in numerous jurisdictions. FFIs do not currently maintain systems that can monitor and compare the knowledge of these vast numbers of employees across branches, business entities and segments. The creation of such systems would be extremely expensive and difficult to implement and even if the construction of such systems were practically achievable, their use may be imper-missible under U.S. and non-U.S. securities, data protection and other laws.162

Waiver of foreign law confidentiality protection. Under the fifth requirement, in order for a foreign financial institution to be Code Sec. 1471(b) compli-ant, it must obtain a valid and effective waiver within a reasonable period of time in any case in which any foreign law would (but for a waiver) prevent the re-porting of information required by Code Sec. 1471(c) with respect to any U.S. account maintained by such institution, and if a waiver is not obtained from each account holder within a reasonable period of time, it must close the account.163

This means that a foreign financial institution will be required to go to each account holder and obtain valid waivers in a form suitable to the IRS for each country, state, canton, province or other foreign jurisdiction that has foreign law confiden-tiality protections and if the investor has accounts in more than one country with such confidentiality protection, multiple valid waivers will have to be

obtained. If they cannot be obtained, the account must be closed.164 According to John Taylor, Esq. from King & Spalding, “Some countries do not al-low investors to waive their privacy rights and if a firm is forced to close the account what happens if the account itself is subject to legal or contractual restrictions regarding its closing. [The new law] defines non–publicly traded debt or equity issued by the financial institution itself as an account, how does a firm comply if the account is a non-callable financial instrument?”

A foreign financial institution will need guidance from the Treasury in any case when it does not obtain a valid waiver from an account holder because (i) the local law precludes the account holder from waiving his or her privacy rights; (ii) contractual limitations preclude such a waiver; or (iii) the account holder refuses to relinquish his or her privacy rights for other reasons. Query, must the FFI close the account or can it begin to withhold on passthrough payments made to such account holder? If the account does not have U.S.-source income or gross proceeds from the sale of U.S. stock or securities, do different rules apply or must the FFI still close the account?

Procedures when information cannot be obtained. The ABA Tax Section Comments to FATCA suggested that procedures needed to be provided under an agree-ment with the Treasury when information cannot be obtained and had the following discussion:165

On the face of the Bill, flawless execution is pre-sumed. An FFI that has entered into an agreement with the Secretary is expected to terminate the account. We believe that the Bill should clarify that, when an FFI has a Code Sec. 1471(b) agree-ment in place, to the extent that information is unobtainable from the holder of a “financial account” despite adequate demands by the FFI, that the Code Sec. 1471(b) agreement is not thereby breached, provided the degree of non-compliance does not indicate a systems failure or abuse of the rules.

The action that should be taken by the FFI may depend on the circumstances. In appropriate cases, the FFI may be required to presume the account to be a U.S. account (including in the case of non–regularly traded debt or equity of the FFI), obligated to withhold at the 30-percent rate on U.S.-source income deemed allocable to the account and deposit the withheld amount with Treasury, and


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should be treated as satisfying its reporting obliga-tion under the agreement by reporting available information (to the extent it can legally report it) in respect of the account holder to the Secretary.166 In other cases, as for example when U.S.-source in-come cannot be associated with the noncompliant account, and the FFI does not choose to deposit the withholding tax out of funds available to it (in effect, self-withhold), it may be more appropriate to require that the account be terminated. Of course, that will not be possible in many situations (includ-ing, e.g., investments in funds and investments in equity or medium- or long-term debt of financial institutions). The Treasury should be authorized to address these issues.

See “Self-Withholding by Foreign Financial Insti-tution is not an Alternative to Obtaining Required Information.”

Election to be withheld upon rather than with-hold on payments to recalcitrant account holders and nonparticipating foreign financial institutions. A foreign financial institution must deduct and with-hold 30 percent from any “passthrough payment” that is made to a (1) “recalcitrant account holder”; (2) foreign financial institution that does not enter into a Code Sec. 1471(b) agreement with the Treasury (a “nonparticipating foreign financial institution”); or (3) foreign financial institution that has elected to be withheld upon, rather than to withhold with respect to the portion of the payment that is allocable to a recalcitrant account holder or nonparticipating for-eign institution.167 A “passthrough payment” means any withholdable payment or other payment that is attributable to a withholdable payment.168 There is no legislative gloss on what it means for a payment to be “attributable” to a withholdable payment.”169 Presum-ably, in response to the ABA Tax Section Comments and others, the new law permits an alternative to flawless execution. More specifically, if a recalcitrant account holder or an upper-tier foreign financial institution does not enter into a Code Sec. 1471(b) agreement, or a foreign financial institution elects to be withheld upon under new Code Sec. 1471(b)(3), this will no longer cause an otherwise complying Code Sec. 1471(b) agreement to fail.170 At least one commen-tator has suggested, “Without this alternative, it could be impossible for some foreign financial institutions to enter into an agreement if the only alternative was to terminate an account even if given a reasonable period of time to obtain information or a confidential-

ity waiver.”171 Another commentator172 suggested the reasons for the passthrough provision by providing, “We understand that the passthrough payment concept was added to the statute to address the concerns that where an investment entity or other FFI is not acting as a custodian or nominee and is not a partnership (or other tax transparent entity) receiving payments on behalf of its partners (or members), payments that it makes to account holders (including investors in its equity or debt instruments) would generally be treated as non-U.S. source income of those account holders and therefore would not be ‘withholdable payments.’ Thus, in the absence of a ‘passthrough payment’ con-cept, FFIs and their account holders would technically fall outside the scope of FATCA withholding.”

However, the requirement for a foreign financial institution to withhold from a noncompliant foreign financial institution raises a host of questions about how a “good bank” will effectuate such withhold-ing from a “bad bank.” That is, will there be blanket withholding on all passthrough payments to non-participating foreign financial institutions and their clients, or will a formulaic approach be adopted to only impose withholding on the accounts beneficially owned by the nonparticipating foreign financial institution or the recalcitrant account holders of the nonparticipating foreign financial institution? If a split rate formula is used, how will the good bank get this information from the bad bank and how will such information be verified to avoid withholding agent liability?173

The “oops” factor. What if a foreign financial in-stitution entered into a Code Sec. 1471(b) agreement with the Treasury, receives withholdable payments and has U.S. accounts, but fails to deduct and with-hold the 30-percent tax on passthrough payments it makes to recalcitrant account holders and non-compliant FFIs under new Code Sec. 1471(b)(1)(D) (and has not made an election under new Code Sec. 1471(b)(3) to be withheld upon rather than withhold on such payments? See “Hybrid FFI Agreement: Elect-ing Out of Withholding Responsibility” and another exemption does not otherwise apply. While it may have entered into a “simplified” Code Sec. 1471(b) agreement (as many commentators have suggested as the best format), it may not have withheld because of its lack of knowledge about the new law and the possibility of making the above election or otherwise chose to ignore it for its own reasons.

An anecdotal example may be useful. For many years, Americans ignored filing FBAR reports for their

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offshore accounts even though the law had been in the place for many years and had significant civil and criminal penalties for failure to file. It was not until the Treasury and DOJ publicized it enforcement initia-tives that significant compliance was undertaken.

Because the new law has a very short implementa-tion period and is generally effective for payments made after December 31, 2012, and because of the possible magnitude of the exposure for noncompliant FFIs, it is important the Treasury provide guidance especially for small foreign financial institutions to give them a better understanding of their potential aggregate exposure (U.S. taxes, interest and penalties) that withholding agents, payors and noncompliant FFIs are facing and also provide them with guidance on remedial measures they may take in the event of inad-vertent and in some cases willful noncompliance. For example, will an FFI or withholding agent be eligible for participation in the voluntary disclosure program to avoid criminal liabilities in the case of an intentional disregard of the new law? Also, can they mitigate their penalties by attempting to become compliant?

For financial statement purposes, since a non-compliant FFI may not have made any inquiries whatsoever as to the whether the accounts are U.S. accounts and may not have deducted and withheld any U.S. tax on any passthrough payments it made to its account holders, who may in fact have been recalcitrant holders or other noncompliant FFIs if reasonable requests had been timely made by the noncompliant FFI, it will likely have a significant ex-posure, which will require a tax reserve to be booked for financial statement purposes for failing to satisfy its own withholding tax responsibilities.

Hybrid FFI agreement: Electing out of withhold-ing responsibility. The HIRE Act permits a foreign financial institution to enter into a “hybrid” agree-ment with the Treasury under which it would not perform the withholding, but would agree to provide sufficient information to the withholding agent or payor that makes a withholdable payment to the foreign financial institution so that the withholding agent can determine how much of the payment is “allocable” to recalcitrant account holders or nonparticipating foreign financial institutions and withhold on that portion of the payment to the for-eign financial institution.

In addition to the electing foreign financial in-stitution providing sufficient information for the withholding agent to determine the proper amount to withhold from recalcitrant account holders and

noncompliant FFIs of the foreign financial institution, it will also have to include in its hybrid agreement with the IRS a waiver of any right under a U.S. tax treaty with respect to such amounts withheld under new Code Sec. 1471(b)(3). The JCT Report indicated that the foreign financial institution waives any right with respect to amounts deducted and withheld with respect to this election. Presumably, this will mean that the withholding agent will withhold a 30-percent tax on all passthrough payments to the foreign finan-cial institution’s recalcitrant account holders and noncompliant FFIs and that these investors or debt holders, as the case may be, will not be able to obtain a refund based upon a reduced rate of withholding under a U.S. tax treaty (although they may be able to do so if another exemption applies under U.S tax law (e.g., portfolio exemption) or if the withholding was attributable to the sale of U.S. stock or securities where no gain was recognized.

While the foreign financial institution may waive its rights to a reduced rate of withholding it is unclear whether it was Congress’s intent to preempt a right an investor or debt holders may have under a U.S. treaty to a reduced withholding rate because they o have failed to provide the information required under new Section 1471(b)(1)(A). It would be helpful if the U.S. Treasury provided clarification on this issue.

The election that allows for withholding on pay-ments made to an account holder that fails to provide the information required under this provision is not intended to create an alternative to information reporting that will still be required to be satisfied. According to the JCT Explanation,174 the Treasury may require under the terms of the Code Sec. 1471(b) agreement that the foreign financial institution achieve certain levels of reporting and make reason-able attempts to acquire the necessary information in order to comply with the requirements of the Code Sec. 1471(b) agreement or to close accounts where necessary to meet the purposes of the law. It is further anticipated that the Treasury may also require under the terms of the Code Sec. 1471(b) agreement that, in the case of new accounts, the foreign financial institu-tion may not withhold as an alternative to collecting the required information. See “Self-Withholding by Foreign Financial Institution is not an Alternative to Obtaining Required Information.”

More specifically, a foreign financial institution may not wish to act as a withholding agent for the payments it makes to other foreign financial institu-tions that either do not enter into Code Sec. 1471(b)


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agreements or themselves have elected not to act as a withholding agent, or for payments it makes to account holders that fail to provide required information.175 Under new Code Sec. 1471(b)(3), such foreign financial institution may elect to have a U.S. withholding agent or payor or a foreign fi-nancial institution that has entered into a Code Sec. 1471(b) agreement withhold on the payments made to the electing foreign financial institution.176 Thus, a foreign financial institution may elect to have a U.S. withholding agent or another foreign financial institution that has entered into a Code Sec. 1471(b) agreement implement the new withholding tax by withholding on passthrough payments made to the electing foreign financial institution rather than (i) acting as a withholding agent for the payments it makes to other foreign financial institutions that either do not enter into 1471(b) agreements (ii) that themselves have elected not to act as a withholding agent and (iii) for payments it makes to account hold-ers that fail to provide the required information.177 If the election is made under new Code Sec. 1471(b)(3), the withholding tax will apply with respect to any withholdable payment made to the electing for-eign financial institution to the extent the payment is “allocable to” accounts held by foreign financial institutions that do not enter into Code Sec. 1471(b) agreements, or to payments made to “recalcitrant account holders.”178

A payment may be allocable to accounts held by a recalcitrant account holder or a foreign financial institution that does not meet the requirements of new Code Sec. 1471(b) as a result of (i) such person holding an account directly with the electing foreign financial institution (ii) in relation to an indirect ac-count held through other foreign financial institutions that either do not enter into a Code Sec. 1471(b) agreement, and (iii) are themselves electing foreign financial institutions.179

The EBF/IIB Comments180 raised the issue how the hybrid election will be administered by providing:

… In many, if not most instances, the entity that would process payments for the electing FFI (either a U.S. withholding agent or another FFI that has built the systems to perform FATCA with-holding) would not be in the position to know of the transactions giving rise to gross proceeds that could be initiated by the electing FFI’s customer since such transactions would not necessarily be processed by the particular withholding agent. We

recognize that this is a complicated issue and we ask that regulations specify how such an election works and what effect it is intended to have.

A question arises as to the withholding agent’s ex-posure if the electing nonparticipating FFI has entered into such hybrid agreement with the Treasury and fails to provide the withholding agent with sufficient information so the withholding agent can timely de-termine how much of the payment to withhold for the recalcitrant account holders or noncompliant FFIs. The Treasury may want to provide guidance as to how a withholding agent determines what amounts should be withheld to avoid withholding agent exposure and what procedures the electing nonparticipating FFI should undertake to remedy deficiencies in informa-tion reporting for its recalcitrant account holders or noncompliant FFIs.

Consent by withholding agent/payor for foreign fi-nancial institution election. Matthew Blum, Executive Director|Tax IRSs/International Capital Markets from Ernst & Young, in a discussion memorandum181 raised the following insightful issues related to a foreign financial institution’s election not to withhold:

If a downstream financial institution elects to be withheld upon rather than to withhold, this will create many of the same issues for an upstream payor as do payments to a qualified intermediary or nonqualified intermediary under current law. The upstream payor will need to do “split rate” withholding, since only the portion allocable to the recalcitrant account holders and non-compliant foreign financial institution customers. Furthermore, if the downstream financial insti-tution is a bank or brokerage, it might only be holding U.S. securities for the account of certain of its customers, and so allocations can change for every payment.

Financial institutions have managed to agree ways to manage these issues under current law, e.g., by developing mechanisms for downstream institu-tions to give allocations information to upstream institutions, or having downstream institutions segregate their holdings into pools with uniform withholding tax characteristics. But it would seem unreasonable to allow a downstream institution to impose these complications unilaterally upon an upstream payor. We suggest that an election by a downstream institution to be withheld upon

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rather than to withhold should require consent by the upstream institution.

Similarly, the EBF/IBB Comments182 raised concerns about making the election automatic or mandatory by providing:

On a practical basis, we strongly recommend that the election not be made either automatic or mandatory. Instead, the FFI that wants to make the election should reach an agreement with the entity that would process the withholding that such election is practicable and can be made to work by both entities since it presents legal and operational challenges and costs for both parties (not to mention upstream withholding agents that might conceivably be several tiers away from one of the FFIs wanting to make the election). We do not believe that it would be fair or commercially reasonable to take a different approach to this elec-tion process. Once the two parties have reached such an agreement, we would propose that there be a relatively easy and automated way for the two parties to notify the IRS of their agreement.

Issues on passthrough payments—foreign banks, insurance companies and multinational corpora-tions. New Code Sec. 1471 requires a withholding agent to deduct and withhold a 30-percent tax on any withholdable payment made to a foreign finan-cial institution that does not enter into a Code Sec. 1471(b) agreement with the IRS and comply with its terms (a “nonparticipating FFI”). It is expected that most foreign banks, insurance companies and mul-tinational corporations that accept deposits, or as a substantial portion of their business hold financial assets for others, or that are engaged primarily in the business of investing or trading in securities, partner-ship interests or commodities will enter into Code Sec. 1471(b) agreements to avoid this withholding tax. Since foreign banks, insurance companies and multinationals typically will have many legal entities, the IRS will also likely require that each of the com-panies include their affiliated companies that have U.S. accounts as part of their “expanded affiliated group” to enter into a Code Sec. 1471(b) agreement as well, unless an exemption otherwise applies. See “New Code Sec. 1471 Applies to “Expanded Affili-ated Group.”

The FFI must determine if payments will be made to recalcitrant account holders or nonparticipat-

ing FFIs. One of the requirements for a foreign financial institution to be compliant under the Code Sec. 1471(b) agreement is that the foreign financial institution must agree if it makes a payment to a recalcitrant account holder who does not provide information about its potential U.S. status or to a nonparticipating FFI, the foreign financial institu-tion must withhold a tax equal to 30 percent on any passthrough payment. As noted, Code Sec. 1471(d)(6) defines a “passthrough payment” as any “withhold-able payment or other payment which is attributable to a withholdable payment.”183 This provision alone will require most, if not all, foreign banks, insurance companies and multinational corporations that are foreign financial institutions to install new processes in order to be compliant and to determine if payments will be made to any recalcitrant account holders or to nonparticipating FFIs. Code Sec. 1471(d)(6) gener-ally defines a “recalcitrant account holder” as one who (i) fails to comply with reasonable requests for information necessary to determine if the account is a U.S. account; (ii) fails to provide the name, address and TIN of each specified U.S. person and each sub-stantial U.S. owner of a U.S.-owned foreign entity; or (iii) fails to provide a waiver of any foreign law that would prevent the FFI from reporting any information required to be reported.

The FFI must determine if a foreign financial in-stitution received “withholdable payments.” The FFI will likely have to determine if they have received any payments that will be treated as “withholdable payments,” subject to the new 30-percent withhold-ing tax if the foreign financial institution does not comply with the Code Sec. 1471(b) agreement. For this purpose, a “withholdable payment” generally includes U.S.-source (i) dividends, (ii) interest, (iii) royalties and other fixed or determinable, annual or periodical income, and (iv) the gross proceeds from the sale of U.S. stock or securities whether or not at a gain. Thus, even if these companies have satisfied the reporting and account verification pro-visions of the Code Sec. 1471(b) agreement with the IRS and believe they are fully compliant, they will nonetheless likely have to install a system that can identify the amount and type of “withholdable payments” they receive and also capture the amount of U.S.- and foreign-source income and gross pro-ceeds from the sale of U.S. stock or securities for each of the above categories of income if they will make payments to recalcitrant account holders or nonparticipating FFIs.


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The FFI must determine the amount of the recal-citrant account holder’s payment that is attributable to a withholdable payment—Tracing issues. Third, the foreign financial institution must determine if the “withholdable payments” it has made to a re-calcitrant account holder or noncompliant FFI are “attributable to a withholdable payment” the FFI has received. Since most, if not all foreign banks, insur-ance companies and multinational corporations who are FFIs will receive both U.S.- and foreign-source income for their own account, and may also receive such income for their customers unless these compa-nies and their customers do not invest in U.S. stock and securities. Presumably, these companies will be able to identify their customers U.S. accounts and to allocate the various categories of income that are attributable to customer deposits, custodial accounts or insurance and other segregated investments under established know-your-customer processes. However, it may be much more difficult for a large foreign bank, insurance company or multinational corporation with global businesses and operations to identify all the “withholdable payments” it receives and also to separate such income or gross proceeds from income effectively connected with a trade or business in the United States (which will not be subject to the new withholding and reporting rules). See “Exception for Income Connected with United States Business.” In addition, it would be helpful if the Treasury provides guidance on an exemption for payments that arise in the ordinary course of business for these companies. See “Identify Other Withholding Tax Exemptions for Certain Payments.” In addition, assuming the global income can be separated based on a separate identification of the companies accounts and businesses on a quarterly or monthly basis, a further step will be required to then allocate the U.S.-source withholdable income and the foreign-source withholdable income to the recalcitrant and nonparticipating FFIs debt and equity holders of these companies in an administra-tively feasible fashion. While these foreign financial institutions may likely know who owns non–publicly traded debt and equity of their foreign bank, insur-ance company or multinational corporation, it will be far more difficult to track and identify the ben-eficial owners of the publicly traded debt or equity of these companies each time a payment is made to a recalcitrant account holder or nonparticipating FFI and to allocate the payments between different categories of income so that it can be determined

what are the passthrough payments subject to with-holding and what are not.

It would be helpful if the Treasury adopted rules that provide taxpayers with guidance on how to allocate the withholdable payment to amounts paid to recalcitrant account holders or noncompliant FFIs. More specifi-cally, the Treasury may want to provide guidance on what allocation methods will be acceptable for pur-poses of allocating the proper amount of U.S. source withholdable payments to passthrough payments made to each recalcitrant account holder or noncompliant FFI, together with examples and also provide guidance that addresses footfalls or errors in making passthrough payments or failures to do so by otherwise compliant foreign financial institutions. Presumably, a true-up mechanism at year-end (or more often) will need to be provided for under withholding on recalcitrant holders and nonparticipating FFIs accounts.

The problem already exists under the current withholding tax rules for U.S. partnerships with for-eign partners. Reg. §1.1441-5(b)(2)(i)(A)) generally provides that a partnership must withhold “when any distributions that include amounts subject to withholding … are made.” One can come up with several possible methods which the Treasury might view as acceptable such as treating a payment as coming out of U.S. source related income first (FIFO) and thus a passthrough payment, or coming out last (LIFO), or using a weighted average or use a method based on some other measure (e.g., fair market value or adjusted bases of the gross assets or net assets or gross income or net income of the foreign financial institution after reducing such income for any income that is effectively connected with a U.S. trade or busi-ness.184 It would be helpful if the Treasury provided taxpayers guidance and at the same time provide wide latitude for taxpayers to adopt reasonable ap-proaches, which the IRS can then verify as being of minimal risk to the fisc.185

If these companies do not distribute or pay out all of their income every year but retain such income in their businesses, will a recalcitrant account holder or noncompliant FFI nonetheless be subject to with-holding on payments the foreign financial institution makes to them? Presumably, the answer is yes. The rules for U.S. partnerships with non-U.S. partners specify in that case, the partnership must withhold on the non-U.S. partners’ share of undistributed income for any particular year when the K-1s for the year for the year are due or distributed, whichever is earlier. It would be helpful if the Treasury provided rules that

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will address for foreign banks, insurance companies and multinationals who are foreign financial institu-tions, which are administratively feasible for both private and public capital markets. One approach would be to follow the qualified intermediary or QI rules and have companies segregate their holdings into pools with uniform withholding characteristics subject to external audits and verification by the IRS for the recalcitrant holders and noncompliant FFIs accounts. If more information is necessary, more de-tailed account information about recalcitrant account holders and noncompliant FFIs accounts could be maintained through these companies’ own records or custodians and transfer agents could be retained to follow rules prescribed by the Treasury to provide de-tail on a capital account-by-capital account basis for both debt and equity owned by recalcitrant account holders or noncompliant FFIs, so that if passthrough payment withholding is required the economic bur-den can be allocated specifically to them.186

If the amounts to be withheld are to be deducted from general assets of the foreign financial institutions, rather than from the segregated customer accounts without assigning the economic burden to any particular re-calcitrant account holder or noncompliant FFI, then the equity holders would be burdened by the behavior of a few. This would seem inequitable and may in fact be illegal.187 A third possibility would be for these companies to set up processes to permit the redemp-tion on a compulsory basis for a sufficient number of shares owned or debt by a recalcitrant account holder or noncompliant FFI to provide the necessary funds to satisfy the withholding tax. This has the advantage of making sure the one who caused the problem, namely the recalcitrant account holders or noncompliant FFI bears the economic cost of their behavior and would still keep the securities fungible.188 There may be an issue for some entities that are part of a large foreign bank, insurance company or multinational corporation may be “hard wired.” That is to say, some securitization vehicles and other funds managed by these companies may have governing documents that may not permit special allocations of a withholding tax to recalcitrant account holders or noncompliant FFIs. It would be helpful if the Treasury considered exemptive rules for such entities if the risk of tax evasion is deemed to be low. In any event, the Treasury may want to con-sider a ceiling rule that limits the aggregate amount of withholding to any recalcitrant account holder or noncompliant FFI to the maximum amount invested in the account plus any income thereto.

Direct tracing analysis. The EBF/IIB Comments189 have taken a different approach to the above analy-sis and have suggested an allocation be made for a withholdable payment to a passthrough payment only where there is a “traceable link” between the account holder and the withholdable payment with the following discussion of the issue:

We believe that the regulations should clearly define what is meant by the statutory definition of passthru payment. The regulations should provide that a payment may be considered at-tributable to a withholdable payment and thus a passthru payment only where there is a trace-able link between the account holder and the withholdable payment. Such a traceable link might exist in the case of an investment entity or investment account in which the account holders are looking to an identifiable portfolio of securities (which might be actively managed in the discretion of the manager) that includes U.S. securities as the source of their returns. We recognize that there may be other such traceable situations that the regulations might want to ad-dress. By contrast, payments that a bank or other financial institution makes from general funds (a “general funds payment”)—such as deposit interest or interest on general debt securities issued by the institution—should not be treated as passthru payments. If all or some propor-tionate share of such payments were treated as passthru payments, it would be extremely dif-ficult for many financial institutions to become participating FFIs (or FFE) and to maintain their U.S. investment activities because they would consider the 30 percent withholding tax to be an unavoidable cost of doing business that, in many cases, would render such activities uneconomic. The numerous interpretive and administrative complexities in determining the amounts subject to withholding, and the operational challenges of implementing such withholding, may also dis-courage financial institutions from participating in the new system.

Moreover, if the passthru payment concept is to be applied to securitization vehicles (such as CLOs, CBOs, etc.) and similar structured finance entities, in which cash flow from U.S. securities may be used to make payments to se-nior creditors while more junior interest holders


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must report (phantom) taxable income, special care will need be taken in crafting clear and precise rules that ensure that the risk of with-holding for noncompliance with the FATCA rules is borne only by the recalcitrant holder or non-complying lower-tier FFI and not by other holders of debt or equity interests in the entity or by the entity itself, since any shifting of such risk could adversely affect the commercial vi-ability of such vehicles.

Recalcitrant account holder. The term “recalcitrant account holder” means any account holder that (i) fails to comply with reasonable requests for informa-tion to determine if an account is a U.S. account;190 (ii) fails to provide the name, address and TIN of each specified U.S. person and each substantial U.S. owner of a U.S.-owned foreign entity;191 or (iii) fails to provide a waiver of any foreign law that would prevent the foreign financial institution from reporting any information required under the law.192

Notification of withholding agent. The electing for-eign financial institution must notify the withholding agent of its election and must provide information necessary for the withholding agent to determine the appropriate amount of withholding.193 The informa-tion may include information regarding the amount of any payment that is attributable to a withholdable payment and information regarding the amount of any payment that is allocable to recalcitrant account holders or to foreign financial institutions that have not entered into Code Sec. 1471(b) agreements.194 See “Consent by Withholding Agent/Payor for Foreign Financial Institution Election.”

How many times and in what manner must an FFI request an account holder for information before the holder is recalcitrant? Matthew Blum also raised important issues in his discussion memorandum195 regarding the identification of recalcitrant account holders by stating:

Code Sec. 1471(d)(6) defines a recalcitrant account holder as one who either (i) does not comply with “reasonable requests” for infor-mation regarding its possible status as U.S. or U.S.-owned, or (ii) does not, upon request, fur-nish a waiver of bank secrecy laws that would prevent reporting of information required to be reported. This raises a number of issues. First, in some situations, the holder of a bank account might instruct a bank not to send account state-

ments or other communications to the account holder, but to hold them for collection when the account holder next visits the bank (a “hold mail” account). It is our understanding that, un-der local law, such an account holder is deemed to be on notice of any correspondence that is made available at the bank him to collect. We also understand that typically, the relationship manager at the bank would know some way of contacting the account holder, even though that information might be highly confidential. In a situation where local “know your customer” rules are not accepted as sufficient, how should a financial institution be deemed to be recalci-trant? Should a “hold mail” account be deemed per se recalcitrant until the account holder comes in to provide the necessary information? Or should banks be allowed to follow whatever procedures are used for other accounts, on the theory that in fact, a diligent relationship manager who was looking out for the interests of the client would find some way to alert the client to the request for information. Second, guidance is necessary on how one identifies a recalcitrant account holder. In other words, how many times and in what manner must one re-quest an account holder to provide the requested information before a financial institution may/must treat an account holder as recalcitrant? The level of detail contained in the rules for “B Notices” under the backup withholding rules, Reg. §31.3406(d)-5, might be too much for a compulsory rule, but query if they suggest what a safe harbor might look like. Do we need to discuss possibility of conflict with local law on authority to withhold?

Waiver of rights under treaty. Additionally, the electing foreign financial institution must waive any rights under a treaty with the United States with re-spect to any amount deducted and withheld pursuant to the new election provision.196

Use of new election for certain other classes or types of accounts. The new law also provides without further explanation in the legislative his-tory that this election may be made with respect to certain other classes or types of accounts of the foreign financial institution to the extent provided by Treasury.197

Abusive transactions. The NYSBA Tax Section spe-cifically raised the issue that there may be avoidance

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transactions possible notwithstanding that withhold-ing will apply to recalcitrant account holders and noncompliant financial institutions by stating:198

We believe that the provisions added to the [Ex-tenders Act] concerning passthrough payments in Code Sec. 1471(a)(1)(D) will assist in deter-ring some abusive transactions. Nonetheless, because reporting applies only with respect to U.S. accounts, and withholding only applies to recalcitrant account holders and noncompliant financial institutions, there are still avoidance transactions that may be possible. For example, no provision of the legislation expressly precludes the following type of arrangement: an account held by a foreign nonfinancial institution that has no United States owners would not expressly be subject to withholding or reporting even if the funds invested by the foreign nonfinancial institution had been loaned in a back-to-back or conduit-type arrangement to the foreign nonfi-nancial institution by a specified U.S. person.

The Treasury Department should be explicitly authorized to combat abusive transactions, in-cluding by requiring withholding on payments made in connection with abusive transactions as if such payments were passthrough payments, or by treating debt holders of a foreign entity as own-ers of the foreign entity, where such withholding or characterization is needed to prevent abuse.

Termination of Code Sec. 1471(b) agreement. If the Treasury determines that the foreign financial institu-tion is out of compliance with a Code Sec. 1471(b) agreement, the agreement may be terminated.199 The new law does not appear to have contemplated that a foreign financial institution that is out of compli-ance with a Code Sec. 1471(b), possibly through no fault of its own will want to remedy any deficiencies rather then suffer the 30-percent withholding tax on withholdable payments.

Guidance by the Treasury to fix noncompliant Code Sec. 1471(B) agreement is necessary. It is presently unclear whether gross noncompliance is required to trigger a termination of a Code Sec. 1471(b) agreement or whether immaterial or technical non-compliance with one or more aspects of the Code Sec. 1471(b) agreement would be sufficient grounds to permit the IRS to terminate the agreement. Presum-ably, the Treasury will provide guidance to assist a

foreign financial institution that has entered into Code Sec. 1471(b) agreement that has one or more deficiencies that may be remedied, or alternatively has acquired a foreign financial institution that has previously entered into Code Sec. 1471(b) agreement with the IRS and is not completely in compliance with the agreement in one or more respects. See “Clarification of Verification and Audit Procedures,” and “Treasury Should Impose Requirements That Are Cost Effective.”

NYSBA Tax Section Comments requests guidance as to the extent of noncompliance necessary for the Trea-sury to revoke the agreement and/or penalize the foreign financial entity. The NYSBA Tax Section Comments raised the issue of the extent of noncompliance to trigger revocation of the Code Sec. 1471(b) agreement:

The statute, however, does not make it clear to what extent the Treasury can take these (or other factors) into account in deciding not to revoke an agreement and/or penalize the foreign financial entity.

We believe that the determination of whether a foreign financial entity is in compliance with the general requirements of Code Sec. 1471 should depend on the nature of the foreign financial entity, the time when the account of the recal-citrant account holder or noncompliant foreign financial entity was established, the proportion of recalcitrant account holders and noncompli-ant foreign financial entities to the investor base of the relevant foreign financial entity, and other similar factors. A one-size-fits-all approach to as-sessing compliance would not be appropriate, as various factors impinge on the ability of a foreign financial entity to be in compliance with these requirements when it’s direct or indirect account holders refuse or are unable to comply. Accord-ingly, we believe that the Treasury Department should be explicitly authorized to determine to what extent compliance with the procedures set forth in Code Sec. 1471(b)(1)(D) and Code Sec. 1471(b)(3) should be deemed to satisfy the requirements of Code Sec. 1471(b)(A) and the re-quirements of the agreement entered into under Code Sec. 1471(b). In that regard, we strongly recommend that the legislative history note the importance of considering the factors described above in making this determination and the need, therefore, for the Treasury Department to


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have the authority to flexibility implement the rules to take into account these considerations.

As a more general matter, we recommend that the legislation direct the Treasury Department to set standards for Code Sec. 1471(b) agreements that encourage foreign financial entities to enter into such agreements and that do not punish foreign financial institutions that are making good-faith efforts to comply with the require-ments. In addition to the authority granted to the Treasury Department to exempt certain classes of institutions under proposed Code Sec. 1471(b)(2), the Treasury Department should also have the power to exempt different types of transactions from these requirements. Either in the statute or legislative history, it should be made clear that revocation of a Code Sec. 1471(b) agreement should not follow from de minimis failures of compliance and that the Treasury Department should have broad authority to excuse failures to obtain the requisite information where rea-sonable efforts have been made by the foreign financial institutions.

New Code Sec. 1471 applies to “expanded affili-ated group.” The law applies with respect to U.S. accounts maintained by the foreign financial institu-tion and, except as provided by the Treasury, to U.S. accounts maintained by foreign financial institutions that are a member of the same “expanded affiliated group” (other than any foreign financial institution that also enters into a Code Sec. 1471(b) agreement with the Treasury).200

Thus, if one member of an “expanded affiliated group” agrees to comply with the law’s reporting provisions and its withholding provisions under new Code Sec. 1471(b)(1)(D) to deduct and withhold a tax equal to 30 percent on passthrough payments to recal-citrant account holders or noncompliant FFIs, or elects to be withheld upon rather than withhold under new Code Sec. 1471(b)(3), by entering into a Code Sec. 1471(b) agreement, all the financial institution mem-bers most likely must abide by these requirements.201

Conversely, if one member of the “expanded affiliated group” is barred from participating in the program by bank secrecy or related laws, or otherwise does not comply with the Code Sec. 1471(b) agreement, all members may be barred from participating and may suffer a Code Sec. 1471(b)(1)(D) withholding tax un-less another exemption otherwise applies.202

In addition, if a former member is no longer part of the expanded affiliated group because it was sold or otherwise disposed of, it may be required to enter into its own Code Sec. 1471(b) agreement presumably on the date it leaves the expanded affiliated group. The Treasury will likely have to provide guidance on the procedures to follow when a entity enters or leaves the expanded affiliated group.

A financial institution would be part of an “expand-ed affiliated group” that includes another financial institution if (i) one financial institution controls the other financial institution directly or through a chain of controlled entities; or (ii) they are both under com-mon control (directly or through a chain of controlled entities) of a single corporation (whether or not such corporation is a financial institution itself).203

More specifically, the new law (and FATCA) defines an “expanded affiliated group” as an affiliated group as defined in Code Sec. 1504(a), but by substituting a more-than-50-percent–ownership requirement for the at-least-80-percent–ownership requirement in each place it appears in Code Sec. 1504(a) (i.e., by vote and value), and disregarding the Code Sec. 1504(b)(2)204 (prohibition on including insurance companies in an affiliated group) and the Code Sec. 1504(b)(3)205 (prohibition on including non-U.S. corporations in an affiliated group). A partnership, trust or any other entity (other than a corporation) will be treated as a member of an expanded affiliated group if such entity is controlled by members of such group.206

Control for these purposes has the same meaning as Code Sec. 954(d)(3) by members of such group including other controlled partnerships or trusts.207

Under this provision, a person is a related person with respect to a controlled foreign corporation if (i) such person is an individual, corporation, partnership, trust or estate that controls or is con-trolled by the controlled foreign corporation;208 or (ii) such person is a corporation, partnership, trust or estate that is controlled by the same person or persons that control the controlled foreign corpo-ration.209 For this purpose, “control” means, with respect to a corporation, the ownership directly or indirectly of stock possessing more than 50 percent of the total voting power of all classes of stock entitled to vote or of the total value of stock of such corporation.210

In the case of a partnership, trust or estate, “control” means the ownership directly or indirectly of more than 50 percent (by value) of the beneficial interests in such partnership, trust or estate.211 The flush lan-

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guage of Code Sec. 954(d)(3) states the rules similar to Code Sec. 958 entitled, “Rules for determining stock ownership,” shall apply. It is likely these constructive ownership rules will also apply for purposes of the new “expanded affiliated group” rules under Chapter 4, but neither the new law nor the legislative history gets into this level of detail. Presumably, the Treasury will provide guidance with examples for taxpayers to rely upon in this area.

Due diligence and verification by foreign financial institutions. It is expected that in complying with the requirements of this law, the foreign financial institu-tion and other members of the expanded affiliated group comply with know-your-customer, anti–money laundering, anti-corruption or other similar rules to which they are subject, as well as with such pro-cedures and rules as the Treasury may prescribe, both with respect to due diligence by the foreign financial institution and verification by or on behalf of the IRS to ensure the accuracy of the information, documentation or certification obtained to determine if the account is a U.S. account. It was pointed out in the legislative history, the Treasury may use exist-ing know-your-customer, anti–money laundering, anti-corruption and other regulatory requirements as a basis in crafting due diligence and verification procedures in jurisdictions where those requirements provide reasonable assurance that the foreign finan-cial institution is in compliance with the law.212

Know-your-customer due diligence. Under the QI program, qualified intermediaries have been able to rely upon know-your-customer documentation. The U.S. know-your-customer rules213 require financial institutions214 to develop and maintain a written customer identification program and anti–money laundering policies and procedures. Additionally, financial institutions must perform customer due dili-gence. The due diligence requirements are enhanced where the account or the financial institution has a higher risk profile.215

A customer identification program at a minimum requires the financial institution to collect the name, date of birth (for individuals), address216 and identi-fication number217 for new customers. In fulfilling their customer due diligence requirements, financial institutions are required to verify enough customer information to enable the financial institution to form a “reasonable belief that it knows the true identity of each customer.”218 In many cases the know-your-customer rules do not require financial institutions to look through an entity to determine its ultimate own-

ership.219 However, based on the financial institution’s risk assessment, the financial institution may need to obtain information about individuals with authority or control over such an account in order to verify the identity of the customer.220 A financial institution’s customer due diligence must include gathering suf-ficient information on a business entity and its owners for the financial institution to understand and assess the risks of the account relationship.221

Enhanced due diligence is required if customers are deemed to be of higher risk, and is mandated for cer-tain types of accounts including foreign correspondent accounts, private banking accounts and accounts for politically exposed persons. Private banking accounts are considered to be of significant risk, and enhanced due diligence requires identification of nominal and beneficial owners for these accounts.222

However, under the existing QI know-your-custom-er rules, a QI generally does not have to look through an entity to determine the ultimate ownership of the account unless the QI has reason to know that the information obtained from its customer is incorrect. Financial institutions must maintain records for a minimum of five years after the account is closed or becomes dormant. They are required to monitor accounts including the frequency, size and ultimate destinations of transfers and must update customer due diligence and enhanced due diligence when there are significant changes to the customer’s profile (for example, volume of transaction activity, risk level or account type). It should also be noted that the Euro-pean Union (EU) also has its own money laundering directive applicable to a broad range of persons including credit and financial institutions.223

Clarification of the extent and application of KYC/AML procedures. According to Stephen Shay, Deputy Assistant Secretary of the Treasury in his tes-timony at the House Ways and Means Subcommittee on Select Revenue Measures on November 5, 2009, on the FATCA legislation, the KYC/AML rules are standards that foreign banks are generally expected to follow to obtain information about their account holders and in the past have been quite helpful and should be used as a base to determine the ownership of these U.S. accounts. It has been suggested the new law goes well beyond these standards because these rules do not typically require financial institutions to look through an entity to determine the ultimate ownership. See “Clarify Standards for Determining U.S. Status of Accounts” and “Substantial United States Owner.” Other than the reference to exist-


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ing KYC and anti–money laundering requirements, the new law does not identify presumptions (and has eliminated the certification safe harbor—see “Elimination of Certification Safe-Harbor”) that foreign financial institutions in the past could rely upon to accomplish the law’s objectives and to ac-commodate the administrative challenges foreign financial institutions will likely have to face in order to implement the new tax regime. In addition, the IRS clearly will need time and resources to evaluate the know-your-customer rules for foreign financial institutions in countries without current approval and to draft and implement written standards and presumptions for the new reporting and withholding requirements. The Treasury may want to consider prescribing transition rules to the extent it is able to do so that address the execution and implementation of the new Code Sec. 1471(b) agreements to bridge the gap from the QI regime224 by utilizing Treasury resources and facilities that will likely be needed to administer the large number of new foreign financial institution agreements contemplated by the law. See “Foreign Financial Institution.”

Staff of the Joint Committee on Taxation Compli-ance and Administrative Concerns—President’s budget proposals KYC and beneficial ownership reporting. The Staff of the Joint Committee on Taxa-tion had the following comments with respect to a President’s Fiscal Year 2010 Budget Proposal, one of the predecessor legislative proposals with respect to the KYC/AML rules to determine the beneficial owner of the accounts:225

For account holders other than individuals, there are generally no prescriptive anti–money laun-dering rules that dictate how or when a financial institution is required to determine the ultimate owners of such accounts.226 Even in countries, such as many in the European Union, where know-your-customer rules require some identifi-cation of ultimate ownership of accounts owned by non-individual, there are minimum ownership threshold levels for obtaining such information and generally no obligation for periodic review of such information. The existing United States know-your-customer rules do not include a general requirement for financial institutions to obtain information on the ultimate owners of domestic or foreign entity account holders, al-though it is required in certain limited situations. The European Union’ know-your-customer rules

normally require identification of some level of beneficial ownership, but not to the extent re-quired under the proposal.

Building upon any relevant information-gathering requirements that already apply to financial in-stitutions would significantly reduce the cost of implementation. The unevenness of those require-ments, however, presents a significant question as to whether existing know-your-customer rules, de-veloped for nontax purposes, will provide sufficient information for tax compliance and enforcement purposes, or whether additional tax-specific rules will be required. The areas in which tax-specific rules may be needed fall into three categories:

Ownership threshold. Even the most compre-hensive know-your-customer rules do not require the identification of every owner of an entity; instead, these rules typically apply some percent-age threshold of ownership (such as 25 percent or 10 percent), or a standard of control, below which identification is not required. Thus, it will be necessary to consider what, if any, threshold should apply for tax purposes.Frequency of review. Although anti–money laundering laws require on-going monitoring of accounts, in general a financial institution is only required to verify know-your-customer information at the time of the account open-ing, when relevant information related to the account changes (such as a new signatory), or upon the occurrence of certain other events that may indicate suspicious activity. In contrast, the IRS Form W-8BEN must be renewed every three years, and existing Treasury regulations governing the more limited circumstances un-der which a U.S. withholding agent or payor may rely on documentary evidence in place of Form W-8BEN for offshore accounts require renewal of that evidence every three years in some circumstances.227 Due diligence requirements. Standards will need to be provided for the extent to which financial institutions are required to undertake indepen-dent investigation of ownership information or instead may rely on documentation (including self-certifications) provided by customers. There is significant inconsistency in the information that is available to financial institutions and other withholding agents for independent verification of ultimate ownership.228

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In addition, it would be desirable to coordinate implementation of beneficial ownership rules to the extent possible with implementation of the owner-ship identification requirements contemplated in other jurisdictions.229

Clarification of verification and audit procedures. Foreign financial institutions will also be required to have procedures in place to ensure compliance with the agreement and verification would include independent review procedures to ensure a foreign financial institution’s compliance with its obligations. As noted above, if the Treasury determines that a for-eign financial institution is out of compliance with the agreement, the agreement may be terminated.

Unlike the Staff of Joint Committee Technical Ex-planation for FATCA,230 neither the new law nor the Staff of the Joint Committee Technical Explanation for the Extenders Act makes any reference to indepen-dent verification and review procedures to ensure a foreign financial institution is compliance with the Code Sec. 1471(b) agreement. Presumably, an inde-pendent review generally will be necessary similar to the external audit procedures currently applicable to QIs unless a waiver is obtained.231

Verification and audit issues—Treasury should impose requirements that are cost effective and consider local law constraints. The procedures to verify U.S. accounts which will be imposed by the Treasury should consider the possible constraints on these procedures as a result of local laws or other nontax regulatory requirements that may make full compliance difficult if not impossible. In such case, a mechanism for a waiver of these requirements in a particular country should be provided.

It has been suggested by one Tax Director232 of a major foreign investment bank that implementation of these new procedures could result in a cost many times greater then in the QI context. More specifi-cally, this Tax Director raised the following issues in connection with the proposed FATCA legislation:233

FFIs that enter into an FFI Agreement would also be required to comply with verification and due diligence procedures as Treasury or the IRS may require. The Joint Committee Explanation of the Bill indicates that verification could in-clude independent review procedures to ensure compliance with an FFI’s obligations under the FFI Agreement. It is unclear whether such an independent review may be analogous to the external audit procedures currently applicable

to QIs. However, in determining the scope of any external audit procedures, it is important to note that applying current QI audit procedures to FFIs could result in costs that are many times greater than in the QI context. QI agreements only apply to a limited subset of designated ac-counts of a financial institution that are chosen for inclusion in the QI arrangement. On the other hand, if, under the FFI Agreement, all accounts of the FFI as well as all accounts of its affiliates are potentially subject to examina-tion, this would be a major concern to the FFI community. Given the vast number of accounts that may be at issue, it is important that the verification procedures not be so burdensome as to dissuade FFIs from entering into a new FFI Agreement.

In lieu of the extreme remedy of terminating and Code Sec. 1471(b) agreement for noncompliance, the Treasury may want to consider prescribing remedial procedures to permit a foreign financial institution to remedy its deficiencies, which can then be reviewed and approved by the IRS. The ABA Tax Section Comments to the proposed FATCA legislation reiterated these concerns and made the following comments:234

An FFI will also be required to have procedures in place to ensure compliance with its Code Sec. 1471(b) agreement, and verification would include independent review procedures to ensure an FFI’s compliance with its obligations. If the Secretary determines that the FFI is out of com-pliance with the Code Sec. 1471(b) agreement, the agreement may be terminated. Given that, unlike the QI system that only applies to a limited subset of designated accounts that are chosen for inclusion in a QI arrangement, a Code Sec. 1471(b) agreement would apply to all accounts of the FFI as well as the accounts of its 50 percent affiliates, the independent review presumably would be designed to be less onerous than the external audit procedures currently applicable to QIs. Procedures separately taking into ac-count the capacities of smaller, non-institutional entities would be appropriate. We recommend guidance in the legislative history indicating that the requirements should be reasonable under the circumstances, taking into account the costs and burdens.


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Self-withholding by a foreign financial institution is not an alternative to obtaining required information. The Staff of the Joint Committee Technical Explana-tion for the Extenders Act indicated that withholding by foreign financial institutions on payments made to an account holder who fails to provide the required information, is not intended to create an alternative to the required information reporting.235 It is anticipated that the Treasury may require under the terms of the Code Sec. 1471(b) agreement that the foreign financial institution achieve certain levels of reporting and make reasonable attempts to acquire the necessary informa-tion in order to comply with the requirements of the Code Sec. 1471(b) agreement or to close accounts where necessary to meet the purposes of the law. It is further anticipated that the Treasury may also require under the terms of the Code Sec. 1471(b) agreement, that in the case of new accounts, the foreign financial institution may not withhold as an alternative to col-lecting the required information.236

Bypassing the FFI agreement: New “deemed compliance” to meet requirements and limited withholding exemptions for foreign financial in-stitutions with no U.S. accounts. Under Code Sec. 1471(b)(2), a foreign financial institution may avoid entering into a Code Sec. 1471(b) agreement with the Treasury if it complies with procedures to be prescribed by the IRS and otherwise satisfies any other requirements by the Treasury to ensure it does not maintain “U.S. accounts.” The Treasury may also exclude certain foreign financial institutions if it determines the goals of the new legislation can be satisfied by other means.

More specifically, the new law (in a provision not in the proposed FATCA legislation) now permits the Treasury to exclude certain foreign financial institutions from entering into a Code Sec. 1471(b) agreement if it determines that such agreement is not necessary for this class of institutions to carry out the purposes of the new law, or if the institution is already subject to similar due diligence and reporting require-ments under other provisions of the Code.

Under this deemed compliance provision, a foreign financial institution may be treated by the Treasury as meeting the requirements in a new Code Sec. 1471(b) if the institution complies with the procedures the Treasury may prescribe to ensure that such institu-tion does not maintain U.S. accounts and meets such other requirements as the Treasury may prescribe with respect to accounts of other foreign financial institu-tions maintained by such institution.237 It is presently

unclear what requirements the Treasury will want to have satisfied in order to obtain the benefit of this safe harbor.

Thus, under new Code Sec. 1471(b)(2), there are two requirements for an FFI to bypass the Code Sec.1471(b) agreement and to be deemed compliant with FATCA: (1) certify it has no U.S. accounts and (2) agree to meet such other requirements as the Treasury may prescribe with respect to accounts of other FFI maintained by such institution. The Treasury should provide guidance how an FFI can initially bypass the Code Sec. 1471(b) agreement and what ongoing requirements must be satisfied to ensure it has no U.S. accounts. Presumably, its customers and its equity and debt holders must also be compliant FFIs or NFFEs (or are otherwise exempt). However, in the event an FFI erroneously obtains U.S accounts or has customers who are noncompliant FFIs, guidance is also needed as to how the FFI can remedi-ate the issue and once again be compliant under new Code Sec. 1471(b)(2).

The EBF/IIB Comments238 suggested the deemed compliance exemption will be used by many foreign financial institutions who have no U.S. accounts and provided the following excellent suggestions to the Treasury:

We believe that many FFIs, including many current QIs, will avail themselves of this pro-vision either because they currently have no U.S. accounts or because they have minimal U.S. accounts and will close their accounts in order to fall under the exception. We have heard many anecdotal examples to date of just such account closures taking place in light of both the trend in U.S. tax law and restrictions under U.S. securities laws.

The Code Sec. 1471(b)(2) exception will be of mutual advantage to both the IRS and the finan-cial community, provided the procedures to meet the exception and to verify that the entity has no U.S. accounts are both sufficiently streamlined. The procedure ideally would be an electronic submission to the IRS that requires the FFI to do the following: (1) certify that it has no U.S. ac-counts; (2) agree to have its name published on an electronically available IRS list that it is an FFI that satisfies the Code Sec. 1471(b)(2) exception; and (3) agree to implement internal procedures which maintain the absence of U.S. accounts. We recognize that the IRS and Treasury are likely

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to consider some sort of verification procedure with respect to those FFIs certifying that they meet Code Sec. 1471(b)(2). As we discuss more fully below, we generally believe that Treasury and the IRS should consider the potential costs and burdens of any such verification requirements in light of the likely low potential for U.S. tax eva-sion through such entities. We assume that an FFI that is also a QI would continue to enjoy the ben-efits of Qualified Intermediary Agreement (“QIA”) status for Chapter 3 purposes. Any external audits to verify whether an FFI has met the Code Sec. 1471(b)(2) exception should be conducted under an “agreed upon procedure” (“AUP”) approach that is substantially less complex than the QI external audit. We anticipate that the same AUPs would apply to both QIs and NQIs, although we assume that such procedures would be built into the QI external audit process and not treated as a separate auditable event for the QI in order to minimize costs to the QI. The IRS should develop a list of the participating FFIs, including those satisfying the [Code] Code Sec. 1471(b)(2) excep-tion, on a current (at least monthly) basis so that the information on the list can be incorporated into the tax withholding and reporting systems of withholding agents making payments to such FFIs. Likewise, the IRS should develop a list of those FFIs that it believes should be treated as per se non-participating, perhaps because the IRS establishes that such FFIs have failed to cure any deficiencies relating to their FFI obligations. The regulations should further provide a reasonable grace period, say 3 months from the date the IRS updates the list, for withholding agents to code their systems with any updated information. An FFI certifying under 1471(b)(2) should be allowed to establish that: (1) it has no FFIs as customers; or, (2) that any FFI customers are participating FFIs under either Code Sec. 1471(b)(1) or (2). For all such customers, the certifying FFI would have no further obligations. However, with respect to any nonparticipating FFIs, the certifying FFI should be allowed either to: (1) withhold any amounts due under FATCA and remit those to the Treasury; or, (2) take advantage of the election to be withheld upon that is contained in [Code] Code Sec. 1471(b)(3).

Safe harbor for expanded affiliation group. Ac-cording to the legislative history, a foreign financial

institution that has a Code Sec. 1471(b) agreement with the Treasury may meet the requirements of new Code Sec. 1471(b) with respect to certain members of its expanded affiliated group, if the affiliated for-eign financial institution complies with procedures prescribed by the Treasury and does not maintain U.S. accounts.239

Safe harbor for certain controlled foreign corpora-tion owned by U.S. financial institutions and certain U.S. branches of foreign financial institutions. The legislative history suggests that the Treasury may also treat controlled foreign corporations owned by U.S. financial institutions and certain U.S. branches of foreign financial institution that are treated as U.S. payors under the Code as meeting the requirements, if such institutions are subject to similar due diligence and reporting requirements under other provisions of the Code.240

Catch-all safe harbor for certain institutions already subject to due diligence and reporting under the Code. The legislative history also suggests that the Treasury may identify other classes of institutions that are deemed to meet the requirements of new Code Sec. 1471(b), provided such institutions are subject to similar due diligence and reporting requirements under other provisions of the Code.241

ABA Tax Section Comments recommending exclu-sions for certain types of investment entities, U.S. branches of a foreign bank or qualified intermediar-ies. The grant of authority provided to the Treasury to prescribe safe harbors or exclusions in appropriate cases was likely based on comments from the ABA Tax Section and others that FATCA was overly broad. The ABA Tax Section had the following comments regarding the proposed FATCA provisions:242

The Bill reflects a determination by its drafters that a distinction between regulated financial institutions, at one end of the spectrum, and passive private investment vehicles, at the other end of the spectrum, would not be meaningful given the objectives of the legislation. We gener-ally agree with this conclusion in principle, but we note that as a result every foreign investment entity however small, and every fund however complex its ownership structure—in each case regardless of its U.S. contacts beyond ownership of instruments paying U.S. source income—would therefore be required to enter into an agreement with the Secretary and undertake the obligations set forth therein or suffer the new


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Code Sec. 1471 withholding tax (which would be nonrefundable for payments it beneficially owns if it is not treaty-eligible. Alternatively, it could drop out of the system by electing not to own U.S. investments.

Further, the Bill reflects a decision to implement a unified foreign account reporting regime that applies to foreign QIs and non-QIs, instead of a two-track approach that would require a new regime for non-QIs and modify the existing QI regime. This approach is in our view the simplest, fastest and on balance most effective way to im-plement the new regime. The QI regime remains relevant to the normal nonresident withholding and backup withholding regimes.

The new requirements would impose not just burdens but also risks of liability for withholding tax on a person entering into a Code Sec. 1471(b) agreement, as well as on an NFFE that receives withholdable payments. We do not have the appropriate expertise concerning the potential effect on investment flows into the United States. Intuitively, one would expect that a significant number of FFIs would opt not to participate and therefore would opt not to hold U.S. investments. The extent of nonparticipation presumably would be affected by choices made in setting forth the requirements of the Code Sec. 1471(b) agree-ment, as well as by the relative size and nature of the FFI and the importance of the U.S. market to its owners or clientele.”

Exception for certain payments. New Code Sec. 1471 does not apply with respect to a payment if the benefi-cial owner of such payment is of the following:243

Any foreign government244 Any political subdivision245

Any wholly owned agency or instrumentality of any one of the foregoing246 Any international organization or any wholly owned agency or instrumentality thereof247

Any foreign central bank of issue248

Any other class of persons identified by the Trea-sury as posing a low risk of tax evasion249

Thus, the withholding tax does not apply to with-holdable payments made to a foreign financial institution if the beneficial owner of such payment is an excluded person. An excluded person will include foreign governments, political subdivisions

or instrumentalities of a foreign government, certain international organizations and foreign banks and any other class of person the Treasury prescribes to exclude from withholding if the Treasury determines that those classes pose a low risk of tax evasion. Que-ry, what is an international organization or any wholly owned agency or instrumentality thereof for purposes of new Code Sec. 1471(f)? The EBF/IIB Comments250 suggested that the exemption for any foreign central bank of issue should be extended by the Treasury to include an “agency or instrumentality” and should receive relief parallel to that for foreign governments and international organizations. The foreign financial institution may also make an election to provide full Form 1099 reporting with respect to each account holder that is a specified U.S. person or U.S.-owned foreign entity and treating the account holder as a U.S. citizen for this purpose. (See “Election to be Subject to the same Reporting as United States Institutions.”) Even if a foreign financial institution has entered into qualified intermediary agreement with the IRS under Code Sec. 1441, it will nonethe-less be required to meet the requirements of a Code Sec. 1471(b) agreement under new Code Sec. 1471 in addition to the reporting and other requirements imposed by the QI rules. See “Code Sec. 1471 Re-quirements are in addition to Section 1441 Reporting Requirements.”

Identify other withholding tax exemptions for cer-tain payments. The legislative history indicates that the Treasury will likely provide guidance to exclude certain payments made for goods, services or the use of property if the payment is made pursuant to an arm’s-length transaction in the ordinary course of business.251

For purposes of this arm’s-length exemption, at least one commentator has suggested that regula-tory guidelines be established as to what factors should be taken into account and explicit regula-tory safe harbors be provided. Some of the factors that have been suggested include (i) whether the payor and the payee are owned or controlled by the same interests for purposes of Code Sec. 482; (ii) whether the payor used competitive bidding or other reasonable methods with vendors to decide on the products or services purchased; (iii) whether the vendor provides the product or service to unrelated third parties; and (iv) whether the payor routinely enters into contracts of a similar nature with a variety of providers for the same or a substantially similar product or service.

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In order that the withholding tax is applied sparingly, commentators have recommended that the Treasury prescribe regulations under the new law that specifi-cally exempts other types of payments or recipients that may be exempted from the withholding process (e.g., vendor payments, bank-to-bank payments, cross-bor-der wire transfers, overnight, short-term and demand credit facilities, letters of credit, revolving credit facili-ties, license agreements, etc.). In addition, accounts payable, installment obligations, commission and bro-kerage fees incurred in the ordinary course of business between unrelated parties at market rates should also be excluded as Chapter 4 “withholdable payments” since the risk of tax avoidance is low. It remains to be seen if the Treasury will permit an exemption for payments in the ordinary course of business between related parties that are otherwise at market rates.

Annual reporting requirements for foreign financial institution. Under the new law, a foreign financial in-stitution must provide the following information each year with respect to each U.S. account:252

The name, address and Social Security number or TIN of each account holder that is a specified U.S. person253 The name, address and Social Security number or TIN of each substantial U.S. owner of any account holder that is a U.S.-owned foreign entity254 The account number255

The account balance or value (determined at such time and in such manner as the Secretary provides256

The gross receipts and gross withdrawals or payments from the account (determined for such period and in such manner as the Secretary may provide257

Contents of foreign financial institution annual report. The FFI agreement will require that a foreign financial institution identify the U.S. accounts and then annually report this information to the U.S. ac-count holders and the Treasury. A foreign financial institution must determine its “financial accounts” and then determine which accounts are held by specified “U.S. persons” or “U.S.-owned foreign entities.”

The reporting requirements apply with respect to U.S. accounts maintained by the foreign financial institution.258 In addition, the reporting requirements also apply to each U.S. account maintained by each other foreign financial institution that is a member of the same expanded affiliated group as such foreign financial institution, other than a foreign financial in-stitution that also enters into a 1471(b) agreement.259

However, the Treasury is authorized to provide ex-

ceptions to this requirement.260 See “New Code Sec. 1471 Applies to “Expanded Affiliated Group.”

Under the HIRE Act, the Treasury is given the authority to except from the reporting requirement information with respect to each U.S. account relat-ing to the gross receipts and gross withdrawals or payments from the account.261 The requirement to obtain the gross receipts and gross withdrawals or payments from the account is not currently required under Code Sec. 1461. See “Reporting Payments and Tax Withheld Under Code Sec. 1461.” While the IRS has not yet provided a draft of the FFI agreement, the new information reporting requirements will likely impose significant and resource intensive changes to the information data collection and reporting processes, even in banks which have quite sophisti-cated technology and processes for their information reporting under Code Sec. 1461.

EBF/IIB Comments—Annual report. The EBF/IIB Comments262 stressed the need to mimimize the content of the annual report to avoid imposing exces-sive costs on foreign financial institutions with the following suggestions:

The EBF and IIB continue to believe that the regulations should require the FFI Annual Report to contain the minimum amount of information necessary for IRS compliance purposes. Each data element that must be captured will increase costs to the FFI. The EBF and IIB are particularly concerned with the obligation for the Annual Report to include the “gross receipts and gross withdrawals or payments from the account [of a U.S. account holder]. The EBF and IIB believe that substantial systems changes may be needed by many FFIs to collect this sort of dynamic data as opposed to static data like name, address, TIN, account number and account balance/value. In addition, the EBF and IIB question whether the information on gross receipts and withdrawals is crucial for IRS compliance efforts. We believe that the IRS should be able to adequately determine whether it should take further investigative steps based on the account balance/value, the location of the account relationship, or the complexity of the structure at issue. Finally, we note that the IRS would retain the authority to request more sub-stantial account data upon specific request to the FFI. We think that this targeted approach makes far more sense than a more systemic one of dubious compliance value.


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The regulations should specify that account bal-ance/value information should be captured at the end of the year. We recommend against an aver-aging regime given that any such regime would increase both complexity and cost to determine and produce the annual report. With respect to account balance information of substantial U.S. owners, we recommend that the regulations per-mit an FFI to choose to report the entire account balance of the entity account, rather than the amount attributable to a substantial U.S. owner based on its ownership percentage (which would add complexity to the reporting process).

In addition, we strongly request that the IRS allow such FFI annual reports to be filed electronically rather than in paper form. We anticipate that the IRS would publish the specifications for such an electronic report to the extent that it agrees to al-low for such submissions. We assume that the FFI annual report will cover a calendar year, and we accordingly request a filing date of June 30 of the year following the end of such calendar year. We also request that with respect to bank account bal-ances, the regulations specify that such balances may be stated in the currency in which they are denominated to ease the filing burdens on FFIs. We believe that a more substantial problem exists with respect to reporting the value of a securities account since many securities may not be readily valued or are subject to frequent fluctuations in value. We request that regulations provide prag-matic rules on what an FFI is expected to report with respect to such accounts.

EBF FATCA Comments—Contents of an FFI report. The EBF FATCA Comments raised practical issues, which the drafters of the new law apparently listened to and gave the Treasury the authority to make certain exceptions from reporting relating to transfers into and out of the U.S. account:263

Recommendation. Code Sec. 1471(c)(1) requires that an FFI that has entered into an FFI agreement must provide the IRS with an annual report pro-viding details about accounts owned by its direct and indirect U.S. customers and lists the items that must be provided in the report with respect to such U.S. accounts. We recommend either that Code Sec. 1471(c)(1)(D) be removed from the Bill (our preferred approach), or that the phrase “To the

extent required by the Secretary” be added as a modifier at the beginning of Code Sec. 1471(c)(1)(D), which requires the FFI to provide the “gross receipts and gross withdrawals or payments from the account (determined for such period and in such manner as the Secretary may provide).”

Rationale. New Chapter 4 presents many op-erational challenges and expenses for financial institutions. We believe that such expenses should be minimized in those instances where the compliance goal of the IRS would not be ad-versely affected and each data element that must be captured and reported necessarily increases the cost of compliance. With respect to the an-nual report, most of the account details required in the annual report are “static” in nature, such as name, address, TIN, account number and ac-count balance at a specified time (presumably year-end). An FFI should be able to capture such data elements even if it must prepare an “excep-tions” report to do so. However, tracking flows into and out of accounts is a much different matter and for some FFIs (or some business lines thereof) would require potentially far greater systems changes. We also question whether this informa-tion is necessary in all instances to provide the IRS with the necessary tools to identify potential U.S. tax evaders, given that the annual report will otherwise identify U.S. persons invested in non-U.S. accounts and securities and which of those U.S. persons have accounts large enough to merit closer IRS examination. Accordingly, we suggest either that proposed Code Sec. 1471(c)(1)(D) be removed from the Bill or, at a minimum, that the Treasury Department be granted flex-ibility to determine the circumstances in which this information must be provided.

Reporting payments and tax withheld under Code Sec. 1461. Form 1042 is used by the withholding agent to report U.S. income tax withheld on certain income of foreign persons and to transmit Form 1042-S. The IRS may require a withholding agent to attach to the Form 1042 a list of all the TINS and corresponding names that have been provided to the withholding agent for the purpose of claiming a reduced rate of withholding tax under an income tax treaty.264 A Form 1042 must be filed on or before March 15 of the year following the year in which the income was paid that is required to be reported on

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an information return on Form 1042-S.265 The 1042 must show the aggregate amount of income paid and tax withheld, which is required to be reported on all the Forms 1042-S for the preceding calendar year by the withholding agent.266

In addition, a withholding agent must prepare a Form 1042-S and furnish to the IRS the following information: (i) the name, address and TIN of the withholding agent; (ii) a description of each category of income paid based upon the income codes pro-vided on the form and the aggregate amount in each category expressed in U.S. dollars; (iii) the rate of withholding applied or the basis for exempting the payment from withholding (exemption codes are provided on the Form 1042-S); (iv) the name and address of the recipient; (v) the name and address of any nonqualified intermediary, flow-through entity or U.S. branch; (v) the taxpayer identifying number of the recipient; (v) the taxpayer identifying num-ber of a nonqualified intermediary or flow-through entity; (vi) the country (based on country codes provided on the form) of the recipient and any of the nonqualified intermediary or flow-through entity, the name of which appears on the form; and (vii) any information required by Form 1042-S or the accompanying instructions.267

Greater clarification and guidance is required on addressing the situation where a foreign financial entity cannot obtain the information required by a Code Sec. 1471(b) agreement. The NYSBA Tax Comments raised the issue whether a foreign fi-nancial institution must close the account if a valid waiver cannot be obtained from the account holder by stating:268

It may not always be possible for foreign fi-nancial entities to obtain and/or provide the information required by a Code Sec. 1471(b) agreement. For example, such information shar-ing may be prohibited by data privacy rules or the confidentiality laws of other jurisdictions. While proposed Code Sec. 1471(b)(1)(F) would require a foreign financial entity to close an account where disclosure of the requisite in-formation is prohibited under foreign law and a valid waiver is not obtained from the relevant holder, this is not always a feasible option. First, some countries do not allow customers to waive privacy laws. Second, a foreign entity may be subject to legal or contractual restrictions on closing accounts, particularly where the “ac-

count” is a debt or equity interest subject to restrictions on redemption. In addition, under the rules of Code Sec. 1471(e), some foreign financial entities may be “affiliates” of other foreign financial entities that they do not con-trol and from whom they cannot (for practical, commercial or legal reasons) obtain the requisite information or force closure of the relevant ac-count at their “affiliate.”

Treasury should provide rules for account data collection and transmission to IRS. As noted above, the new law requires foreign financial accounts to provide the account number, account balance or value, gross receipts and gross withdrawals or pay-ments from the account at such time, and in such manner as the Treasury may prescribe. Such infor-mation would likely include information about the identities of the owners of the non–publicly traded debt or equity in the foreign financial institution, as well as information regarding both U.S.-source and foreign-source payments. The Treasury may want to consider what details about what is required to be provided for each account under the law will need to be expanded upon and elaborated on, as well as the details of the time and manner of col-lecting this information and reporting it to the IRS. Some commentators have suggested that rules be adopted by the Treasury for the new regime that makes clear what information needs to be trans-mitted to the IRS as well as the timing and mode of transmission. The ABA Tax Section Comments also followed this approach by stating:269 “We rec-ommend that, considering the additional burdens involved, withdrawals or payment information (as opposed to account balances or value) is required only to the extent the Secretary determines that such information is necessary or appropriate.”

Full U.S. reporting alternative: Election to be subject to the same reporting as U.S. financial in-stitutions. As an alternative to annual reporting and possible withholding, a foreign financial institution may make an election enter into an agreement with the IRS to report under Code Sec. 6041 (informa-tion at source), Code Sec. 6042 (returns regarding payments of dividends and corporate earnings and profits), Code Sec. 6045 (returns of brokers) and Code Sec. 6049 (returns regarding payments of interest). One of the principal deterrents to an FFI electing full 1099 reporting will likely be the re-quirement for the FFI to comply with new cost-basis


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reporting as part of its agreement with the Treasury to elect to be subject to the same reporting as a U.S. financial institution.

The foreign financial institution must still enter into an agreement with the Treasury that specifies it will provide full 1099 reporting to the government. Under the full 1099 reporting regime, however, the foreign financial institution will no longer have to report account balances or values or gross receipts or withdrawals but, as explained below, must treat each “specified U.S. person” or “U.S.-owned foreign entity” as a natural person and citizen of the United States for purposes of 1099 reporting.

Purpose and mechanics of election. Under this election, the foreign financial institution reports on each account holder that is a specified U.S. person or U.S.-owned foreign entity as if the holder of the ac-count were a natural person and citizen of the United States.270 As a result, both U.S.- and foreign-source amounts (including gross proceeds) are subject to reporting under this election regardless of whether the amounts are paid inside or outside the United States.271 The election will be made at the time and in the manner and subject to such conditions as the Treasury may provide.272 The election can be made by a foreign financial institution even if other mem-bers of its expanded affiliated group do not make the election.273

According to at least one commentator,274 “prior to making this election, non-U.S. financial institu-tions should consider the differences between the applicable information reporting rules for U.S. and non-U.S. financial institutions. For instance, some non-U.S. financial institutions may regard the needed changes to internal procedures, IT or other systems to comply those information reporting rules applicable to U.S. financial institutions as too burdensome, while others may not maintain certain records needed to comply with certain information reporting rules applicable to U.S. financial institutions, such as tax basis reporting.”

The EBF/IIB Comments275 raised a technical issues whether any Form 1099 reporting that is currently done by a QI or a withholding agent must continue once it becomes a participating foreign financial institution and also raised the issue as to how the QI rules will be rationalized with the new FATCA rules by providing:

We request clarification as to whether any current Form 1099 reporting that is being performed by

a QI or a U.S. withholding agent receiving Forms W-9 from either a QI or an NQI would continue once such QI or NQI becomes a participating FFI. We believe that one way to read FATCA is that the FFI annual report would supplant such Form 1099 reporting. However, we recognize that this likely is inconsistent with the purpose of FATCA to expand information reporting with respect to U.S. taxpayers. Accordingly, it would be helpful if this were clarified. Likewise, it would be help-ful if the regulations clarify that if an FFI assume Form 1099 reporting and a U.S. person refuses to provide a TIN, then the FFI would backup with-hold on payments made to such account under Code Sec. 3406 and FATCA withholding would not apply.

Finally, we believe that there generally will be a need for the QI community along with Treasury and the IRS to consider and rationalize the new FATCA rules with existing QIA obligations. For example, it is unclear how FATCA’s goal of identi-fying U.S. accounts relates to the QIA obligation to perform Form 1099 reporting based upon “where payment is made” and “where sales are effected” (similar changes are also warranted in the analogous Code Secs. 6045 and 6049 regu-lations). Such rules act as an indirect way for a QIA to disclose U.S. account holders invested in non-U.S. bank and security accounts under cer-tain limited circumstances. These and other rules would benefit from a thorough reexamination.

Annual reporting requirement. If a foreign finan-cial institution makes this election, the institution is also required to report the following information with respect to each U.S. account maintained by the institution:

The name, address and TIN of each account holder that is a “specified U.S. person”The name, address and TIN of each “substantial U.S. owner” of any account holder that is a “U.S.-owned foreign entity”The account number276

SIFMA Comments recommend simplified 1099 reporting by foreign financial institutions in lieu of full reporting now required under alternative regime. According to the SIFMA Comments for the proposed FATCA legislation, the alternative reporting election available to foreign financial institutions should allow for simplified Form 1099 reporting, rather than full

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Form 1099 reporting (which is now required under the new law, absent Treasury guidance to the contrary), in order to induce more foreign financial institutions to elect this more useful reporting alternative.277 More specifically, the SIFMA Comments provide:278

The Bill is responsive to many of the concerns expressed in SIFMA’s prior comment letter on the Obama Administration’s offshore tax compli-ance proposals. SIFMA in particular welcomes the Bill’s simplified reporting regime for FFIs that would apply as default matter (the default reporting regime”). SIFMA also welcomes the flexibility provided by the election to opt for full Form 1099 reporting if an FFI so desires. The latter election would be much easier for FFIs to implement, however, and thus much more likely to be adopted, if it provided for simplified Form 1099 reporting would require. SIFMA would be pleased to work with the Treasury Department and the IRS to develop a process for such simpli-fied Form 1099 reporting.

In general, SIFMA contemplates that such re-porting would be limited to cash payments, and would not require an FFI to, e.g., report any income on an accrual basis, deemed income, adjusted tax basis, or any supplemental informa-tion that might be otherwise be required. This would mean that am FFI would report cash pay-ments of dividends, interest, royalties and gross proceeds from the sales of securities, but would not be required to report accruals of original is-sue discount on long-term obligations, foreign tax withheld, deducted investment expenses, adjusted issue price, market discount informa-tion on REMICs or CDOs, imputed income or supplemental information on a widely held fixed income trust, or similar tax information. This would obviate the need, among other things, to reclassify income paid, track holding periods, and make complicated tax calculations to determine income amounts, or perform tax lot accounting for securities sold in order to prepare Form 1099s. SIFMA believes that these simplifications would not significantly impair the IRS’s ability to combat offshore tax evasion, and that the simplified Form 1099 information would indeed be substantially more useful to the IRS than the information that it would receive under the default reporting regime. As a consequence, SIFMA believes the goals of

the Bill would be advanced by providing for a simplified Form 1099 reporting alternative.

Code Sec. 1471 requirements are in addition to Code Sec. 1441 reporting requirements for qualified intermediaries. The drafters of the new law made clear that in both the statute and legislative history that in the case of a foreign financial institution that is treated as a qualified intermediary by the Treasury for purposes of Code Sec. 1441 and the regulations thereunder, the requirements of new Code Sec. 1471 will be in addition to any reporting or other requirements imposed by the Treasury under the QI or similar agreement.279

The qualified intermediary program. A “qualified intermediary” or QI is defined as a foreign financial institution or a foreign clearing organization other than a U.S. branch or U.S. office of such institution or organization or a foreign branch of a U.S. financial institution that has entered into a withholding a report-ing agreement (“QI agreement”) with the IRS.280

A foreign financial institution that becomes a QI is not required to forward beneficial ownership informa-tion with respect to its customers to a U.S. financial institution or other withholding agent of U.S.-source investment-type income to establish the customer’s eligibility for an exemption from or reduced rate of U.S. withholding tax.281 Instead, the QI is permitted to establish for itself the eligibility of its customers for an exemption or reduced rate, based on an IRS Form W-8 or W-9 or other specified documentary evidence and information as to residence obtained under the know-your-customer rules to which the QI is subject in its home jurisdiction as approved by the IRS or as specified in the QI agreement.282 The QI certifies as to eligibility on behalf of its customers, and provides withholding rate pool information to the U.S. withholding agent as to the portion of each payment that qualifies for an exemption or reduced rate of withholding. The IRS has published a model QI agreement for foreign financial institutions.283 A prospective QI must submit an application to the IRS providing specified information, and any additional information and documentation requested by the IRS. The application must establish to the IRS’s satisfaction that the applicant has adequate resources and proce-dures to comply with the terms of the QI agreement. Before entering into a QI agreement that provides for the use of documentary evidence obtained under a country’s know-your-customer rules, the IRS must receive (1) that country’s know-your-customer prac-


July 2010

tices and procedures for opening accounts and (2) responses to 18 related items.284 If the IRS has already received this information, a particular prospective QI need not submit it again. The IRS has received such information and has approved know-your-customer rules in 59 countries.

A foreign financial institution or other eligible person becomes a QI by entering into an agreement with the IRS. Under the agreement, the financial institution acts as a QI only for accounts that the financial institution has designated as QI accounts. A QI is not required to act as a QI for all of its ac-counts; however, if a QI designates an account as one for which it will act as a QI, it must act as a QI for all payments made to that account. The model QI agreement describes in detail the QI’s withholding and reporting obligations.

Withholding and reporting responsibilities. As a technical matter, all QIs are withholding agents, for purposes of the nonresident withholding and report-ing rules, and payors (who are required to withhold and report), for purposes of the backup withholding and Form 1099 information reporting rules. How-ever, under the QI agreement, a QI may choose not to assume primary responsibility for nonresident withholding. In that case, the QI is not required to withhold on payments made to non-U.S. customers, or to report those payments on IRS Form 1042-S. In-stead, the QI must provide a U.S. withholding agent with an Form W-8IMY that certifies as to the status of its (unnamed) non-U.S. account holders and with-holding rate pool information.

Similarly, a QI may choose not to assume primary responsibility for Form 1099 reporting and backup withholding. In that case, the QI is not required to backup withhold on payments made to U.S. customers or to file Forms 1099. Instead, the QI must provide a U.S. payor with an IRS Form W-9 for each of its U.S. non-exempt recipient account holders (i.e., account holders that are U.S. persons not generally exempt from Form 1099 reporting and backup withholding).285

A QI may elect to assume primary nonresident withholding and reporting responsibility, primary backup withholding and IRS Form 1099 reporting responsibility, or both.286 A QI that assumes such re-sponsibility is subject to all of the related obligations imposed by the Code on U.S. withholding agents or payors. The QI must also provide the U.S. with-holding agent (or U.S. payor) additional information about the withholding rates to enable the withhold-ing agent to appropriately withhold and report on

payments made through the QI. These rates can be supplied with respect to withholding rate pools that aggregate payments of a single type of income (e.g., interest or dividends) that is subject to a single rate of withholding.

If a U.S. nonexempt recipient has not provided an IRS Form W-9, the QI must disclose the name, ad-dress, and taxpayer identification number (TIN) (if available) to the withholding agent (and the withhold-ing agent must apply backup withholding). However, no such disclosure is necessary if the QI is, under local law, prohibited from making the disclosure and the QI has followed certain procedural requirements (including providing for backup withholding).287

Several commentators have suggested that every effort should be made to develop an integrated in-formation reporting, which will avoid duplication of reporting under the existing QI regime and the new reporting requirements of Chapter 4. Similarly, seri-ous effort should be undertaken by the Treasury to develop a cogent set of KYC rules that captures the requirements of both regimes to the extent necessary. See “NYSBA Tax Section Comments—Integration of Existing QI Regime.”

NYSBA Tax Section Comments—Integration with existing QI regime. The NYSBA Tax Section Com-ments have recommended that the Treasury be given the authority to efficiently buckle new Chapter 4 into the existing QI regime by stating:288

The Treasury Department, either explicitly or in the legislative history, should be given the au-thority in order to carry out the purposes of both Chapter 3 and the new Chapter 4 of the Internal Revenue Code, to modify the rules under the new Chapter 4 as necessary or appropriate so that the rules are integrated and consistent with the existing QI regime under Chapter 3. While proposed Code Sec. 1471(d)(1)(C) would allow the Treasury to exempt an account from report-ing if the Treasury Department determines the holder of such account is otherwise subject to information reporting requirements that would render Code Sec. 1471 reporting duplicative, we believe this authority to harmonize the two reporting regimes even in circumstances where the Chapter 4 requirements do not duplicate the Chapter 3 requirements. Stated somewhat dif-ferently, the Treasury Department should have the specific authority to modify the rules under Chapter 4 as necessary to make the requirements

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consistent with the QI regime where it determines that those rules are sufficient and appropriate. This regulatory discretion would facilitate the elimination of potentially inconsistent or unnec-essarily burdensome reporting requirements for financial institutions that currently participate in the QI regime.

Staff of the Joint Committee on Taxation Com-pliance and Administrative Concerns—President’s budget proposals. The Staff of the Joint Commit-tee on Taxation had the following comments with respect to a President’s Fiscal Year 2010 Budget Proposal, one of the predecessor legislative proposals that would require a foreign financial institution to identify all of its account holders that were U.S. persons:289

The proposal would not, in and of itself, preclude a U.S. person from evading tax by opening an offshore account with a foreign financial institu-tion that is not a QI and thus is not required to perform information reporting. A foreign financial institution that has no U.S. connection clearly falls outside the jurisdiction of the U.S. tax laws and cannot be required to comply with U.S. reporting requirements.

It may be difficult and costly, however, for QIs to comply with all of the information report-ing requirements that apply to U.S. financial institutions. Most QIs would need to under-take significant modifications to their existing computer systems in order to capture the ad-ditional information required and prepare the information returns. In addition, the existing information reporting requirements require in many instances a sophisticated knowledge of U.S. tax rules, for example with regard to the classification of financial instruments, the computation of original issue discount (for se-curities acquired on or after January 1, 2011) the determination of tax basis. Applying these

rules with respect to complex financial instru-ments that are issued by foreign persons may be particularly difficult, in view of the absence of reporting or disclosure by the issuer on U.S. tax characteristics.290

Concerns have been expressed by international financial institutions that the exportation of the U.S. information reporting requirements—even with a reasonable transition period—will impose too great an administrative burden on QIs and will result in many QIs leaving the system.291Many foreign financial institutions do not have the technical expertise needed to ensure compliance with U.S. withholding and reporting requirements, in particular with regard to foreign securities. In addition, institutions with relatively few U.S. customers, or relatively few customers who invest in U.S. securities, may find that the costs of compliance with the full range of U.S. reporting rules outweigh the benefits they derive from QI status.

The new law requires that a foreign financial institution provide on at least an annual basis the name, address, TIN, account number, account balance or value, gross receipts and gross withdraw-als or payments from the account as the Treasury should prescribe for each specified U.S. person or substantial U.S. owner. Presumably, the new law stopped short of full 1099 reporting currently required by U.S. financial institutions based upon the above concerns by the Staff of the Joint Com-mittee on the President’s Fiscal Year 2010 Budget Proposal as well as other commentators. However, the administrative burden of implementing even these reporting requirements by foreign financial institutions and nonfinancial foreign entities should not be underestimated. See “Clarify Standards for Determining U.S. Status of Accounts,” “Verification and Audit Issues—Treasury should impose Require-ments that are Cost Effective,” and “Nonfinancial Foreign Entity Diligence.”

EndnotEs1 Update on Reducing the Federal Tax Gap

and Improving Voluntary Compliance, U.S. Department of the Treasury, July 8, 2009; U.S. Senate, Permanent Subcommittee on Investigations, Committee on Homeland Security and Governmental Affairs, Tax Haven Banks and U.S. Tax Compliance, Staff

Report (July 17, 2008) (“the Report). 2 Blake Ellis, Tax audits: Uncle Sam wants

you! CNN Money.com, Feb. 17, 2010.3 Mark Nestmann, IRS Targets U.S. Citizens

Living Abroad, iStockAnalyst.com, Feb. 19, 2010.

4 Section 501(a) of the Tax Extenders Act

of 2009, H.R. 4213, 111th Cong. (2009) (hereinafter referred to as “Extenders Act”).

5 While the article does provide an analysis of the new withholding and reporting require-ments for foreign account compliance, it not address the new rules for the treatment of foreign trusts nor the new business tax


July 2010

provisions or tax incentives generally for em-ployers who hire or retain new employees. However, it should be noted the HIRE Act delays the effective date of the worldwide interest allocation rules to December 31, 2020, and accelerates the schedule under which corporate taxpayers with assets of at least $1 billion will be required to pay estimated taxes.

6 Patriot Act (P.L. 107-56) (Oct. 26, 2001).7 Act Sec. 352 of P.L. 107-56, codified at 31

USC §5318(h).8 Act Sec. 326 of P.L. 107-56, codified at 18

USC §5318(l).9 See 31 CFR §103.170, as codified by interim

final rule published at 67 FR 21110 (Apr. 29, 2002), as amended at 67 FR 67547 (Nov. 6, 2002) and corrected at 67 FR 68935 (Nov. 14, 2002); Advance Notice of Proposed Rulemaking on Anti–money laundering Program Requirements for “Persons Involved in Real Estate Closings and Settlements,” 68 FR 17569 (Apr. 10, 2003).

10 18 USC §371.11 The FATCAT legislation doubled the 20-per-

cent accuracy-related penalty to 40 percent. See “Code Sec. 6662 Civil Accuracy-Related (Negligence) Penalty.”

12 Under the proposed legislation entitled, “America’s Affordable Health Choices Act of 2009,” the substantial understatement of income tax attributable to a “tax shelter,” the “reasonable cause and good faith” defense available under current law to imposition of Code Sec. 6662 penalty would cease to be available, thereby imposing the penalty on a “strict liability” basis in the case of “tax shelters.” Code Sec. 6662(d)(2)(C)(ii) defines “tax shelter” to mean a “partnership or other entity, any investment plan or arrangement, or any other plan or arrangement, if a signifi-cant purpose of such partnership, entity, plan or arrangement is the avoidance or evasion of Federal income tax.”

13 15 USC §78(o)(a); Rule 13a-11. 14 15 USC §80b-(3)(a).15 Under the codification of accounting stan-

dards, the relevant portions of FIN 48 are now contained in Accounting Standards Codification subtopic 740-10, Income Taxes. FASB ASC 740-10.

16 Wall Street Tax Association—Accounting for Income Taxes Presentation, slide #14 (Feb. 18, 2010).

17 Id.18 Floyd Norris, Demystify the Lehman Shell

Game, n.Y. TiMes, Apr. 2, 2010. While the article does not address disparities in the tax treatment of transactions by the parties, such as between a buyer and seller or lender and borrower, it raises the issue that the SEC may be digging deeper into the accounting practices of the parties to a transaction. It is possible the IRS may adopt a similar audit approach, especially when now armed with “uncertain tax position statements” from

taxpayers on both sides of a transaction who may have reported the tax treatment of the same transaction quite differently.

19 Wall Street Tax Association—Accounting for Income Taxes Presentation, slide #16 (Feb. 18, 2010).

20 Lynnley Browning, Deal on Names Cracks at Swiss Banks, n.Y. TiMes, Aug. 20, 2009, at 1.

21 On Aug. 15, 2009, it was reported in Bloomberg.com by David Voreacos and Car-lyn Kolker that John McCarthy, a California client of UBS, agreed to plead guilty in U.S. District Court (Central District of California (Los Angeles) to a charge of failing to file an FBAR and pay a penalty equal to 50 percent of the highest balance of his COGS account since 2003. See U.S. v. John McCarthy, CR # 09-00784, U.S. District Court, District of California (Los Angeles). “The case against Mr. McCarthy is the latest victory in the Justice Department’s crackdown on offshore tax evasion,” said John DiCicco, acting Assistant Attorney General for the Justice Department Tax Division in a statement. McCarthy opened a Swiss account in 2003 in the name of COGS Enterprise Ltd, a Hong Kong entity, and failed to file FBARs. McCa-rthy skimmed money from his U.S. business into a domestic bank account in 2003 and with the help of UBS representatives and his Swiss lawyers transferred that money into his COGS account in Switzerland. McCarthy, a resident of Malibu, California met with UBS bankers and his Swiss lawyers over the next five years to discuss UBS accounts. His Swiss lawyer advised him to set up a Liechtenstein foundation or a Panamanian or Hong Kong corporation to “create an extra layer of privacy” and help hide his identity according to the plea agreement. It was also reported August 22, 2009, that another ex-UBS banker, Bradley Birkenfeld, who as-sisted governmental investigations probing the UBS offshore accounts was sentenced to more than three years in prison for help-ing wealthy Americans evade tax. See Erik Larson and Carlyn Kolker, UBS Tax Fraud Case Whistleblower Gets 40-Month Prison Sentence, Bloomberg.com, Aug. 22, 2009.

22 Peter D. Hardy and Thomas E. Zehnle, Deferred Prosecution Agreement Struck with Swiss Bank UBS as Government Tightens Enforcement Net around Foreign Accounts, www.abanet.org/crimjust/wcc/newsletter309.htm. According to the article, the deferred prosecution agreement is sup-ported by a detailed statement of facts that “alleges that private bankers and managers working for UBS in its U.S. cross-border business participated in scheme to defraud the IRS by facilitating for U.S. taxpayers the creation of accounts in the names of offshore accounts in the names of offshore entities, thereby allowing the U.S. taxpay-ers to evade their reporting requirements.

Some of the alleged misconduct involved the manipulation and falsification of forms required under a ‘Qualified Intermediary Agreement’ that UBS had entered into with the IRS, in which the bank agreed to identify U.S. clients who held U.S. investments or received U.S. source income in their for-eign accounts. The statement of facts also alleges that UBS private bankers routinely traveled to the United States to meet with clients and received training on how to avoid detection by U.S. authorities. It further describes inadequate compliance systems at UBS.” See also Stephanie Meltzer, Patrick Pericak and Shelly Goldklang, IRS Offers to Ease Penalties for Taxpayers Who Disclose Their Overseas Accounts in the Wake of the Department of Justice’s Continuing Crack-down on the Use of Tax Havens, Cadwalader ClienTs & Friends MeMo, Apr. 14, 2009. The Qualified Intermediary or QI program was intended to put the burden of information reporting and withholding tax returns on the foreign financial institutions who were presumably closer to their customers under “know your customer,” or KYC, principles. The theory being that the foreign financial institutions would not only be in the best position to collect the required documenta-tion (e.g., Forms W-8s, W-8BENs, W-8IMYs or W-9s), but would also be able to verify that such information about their clients was correct. Reg. §1.1441-1(e)(5). At the time the QI program was adopted, the IRS explained its scope and purpose in An-nouncement 2000-48, 2000-1 CB 1243. A Form W-9 discloses the taxpayer’s name, address and taxpayer identification number and notifies recipients such as UBS that they are generally required to withhold from such taxpayers at a rate of 28 percent if such information is not disclosed and a taxpayer certification obtained.

23 Kim Dixon and Dan Margolies, U.S. look-ing at 7000 accounts at foreign banks, CNNMoney.com, Feb. 25, 2010); Tom Bur-roughes, U.S. Tax Authorities Probe More Than 7,000 Foreign Accounts, Go Beyond UBS, wealTh BrieFing, Feb. 26, 2010.

24 Baucus, Rangel, Kerry, Neal Press Release on Foreign Account Tax Compliance Act of 2009 (Oct. 27, 2009).

25 Id.26 Code Sec. 163(f)(2)(B) provides, “Certain

obligation not included. An obligation is described in this subparagraph if—(i) there are arrangements reasonably designed to ensure that such obligation will be sold (or resold) in connection with the original issue) only to a person who is not a U.S. person, and (ii) in the case of an obligation not in registered form—(I) interest on such obliga-tion is payable only outside the United States and its possessions and (II) on the face of such obligation there is a statement that any U.S. person who holds such obligation will

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be subject to limitations under the United States income tax laws.”

27 Statement by President Barack Obama on House and Senate Introducing Legislation to Crack Down on Overseas Tax Havens, Oct. 27, 2009.

28 William J. Wilkins, IRS Chief Counsel, testified on November 5, 2009, before the House Ways and Means Subcommittee on Select Revenue Measures on FATCA stating: “Under the bill, a [nonqualifying intermedi-ary] would be subject to withholding unless it enters into an agreement with the IRS and complies with the associated reporting, due diligence, and verification obligations with regard to its direct and indirect U.S. custom-ers. The bill would, therefore, create a strong incentive for global foreign financial institu-tions to provide the IRS with the information it needs to ensure that U.S. account holders are complying with US tax laws.”

29 Baucus, Rangel, Kerry, Neal Press Release on Foreign Account Tax Compliance Act of 2009, Oct. 27, 2009.

30 On December 3, 2009, the American Bar Association Section of Taxation submitted comments to the Senate Finance Commit-tee and House Ways and Means Committee entitled, Comments on Foreign Account Tax Compliance Act of 2009, H.R. 3933 and S. 1934 (hereinafter referred to as “ABA Tax Section Comments”). See ABA Tax Section Comments, at 5.

31 On March 2, 2009, Senator Carl Levin introduced legislation entitled the Stop Tax Haven Abuse Act, S. 506, H.R. 1265, 111th Cong. (2009) (hereinafter referred to as “Levin Bill”).

32 ABA Tax Section Comments, at 5.33 ABA Tax Section Comments, at 5–6.34 Act Sec. 501 of the Extenders Act.35 The Joint Committee on Taxation estimated

that the tax enforcement provisions of the law would raise $7.67 billion over the next 10 years, a somewhat lower figure than the $8.5 billion that had been originally estimated for FATCA. This reduction in rev-enue has been attributed to delays in the effective date of certain provisions of the law, when compared to the original provi-sions of FATCA. See Chuck O’Toole, Rangel Introduces Tax Extenders Package as House Schedules Vote, 2009 TNT 233-2 (Dec. 8, 2009). However, in this “pay-go” environ-ment in Congress, the new law would likely be counted as a revenue raiser to pay for desired tax breaks and is in high demand. See Mark A Luscombe, Tax Trends, Foreign Account Tax Compliance, Taxes, Feb. 2010, at 3.

36 ABA Tax Section Comments, at 6–7. 37 New York State Bar Association Tax Section

comments dated January 10, 2010, entitled, Comments on the Foreign Account Tax Com-pliance Legislation (hereinafter “NYSBA Tax Section Comments”), at 4.

38 See written Testimony of Douglas H Shul-man, Commissioner, IRS Hearing on Tax Haven Banks and U.S. Tax Compliance Before the Permanent Subcommittee on Investigations, S. Committee on Homeland Security and Governmental Affairs, 110th Congress, July 17, 2008.

39 BSA Regulation 103.24 requires a report termed, Report of Foreign Bank and Fi-nancial Accounts, or FBAR, TD F 90-22.1 to be filed by “each person subject to the jurisdiction of the U.S. (except a foreign subsidiary of a U.S. person) who has a finan-cial interest in, or signature authority over a bank, securities or other financial account in a foreign country for each year in which such relationship exists.” 31 CFR §103.24(a); inTernal revenue Manual (hereinafter referred to as “IRM”) §4.26.16.2.2.

40 Chris Kentouris, Curbing Tax Evasion: Do You Know Where Your Data Is? seCuriTies indusTrY news, Jan. 25, 2010.

41 According to comments dated October 30, 2009, provided by Sullivan & Cromwell LLP entitled Foreign Account Tax Compliance Act Introduced in Congress (hereinafter termed “Sullivan & Cromwell FATCA Com-ments”), at 6–7.

42 Kentouris, supra note 41.43 New York State Bar Tax Section Comments,

at 3–4.44 Id. 45 Conference call with Alan Granwell, a Tax

Partner at DLA Piper (April, 2010). 46 Urs P. Roth, CEO Swiss Bankers Association,

Tour d’horizon, Media ConFerenCe, Sept. 17, 2009.

47 Id., at 3; David Holmes, CS sees withholding tax on Germans’ accounts paper, reuTers, Mar. 15, 2010.

48 Act Sec. 501 of the HIRE Act. 49 Code Secs. 3406, 6041–6049, and the

Treasury Regulations thereunder. Unless oth-erwise indicated, all Code Sec. references are to the Internal Revenue Code of 1986 (“the Code”), as amended, or the Treasury Regulations thereunder. U.S. persons may be subject in certain cases to a backup withholding tax with respect to payments of investment income and serves to support the regular information and reporting and tax return requirements for U.S. persons and does not apply where the U.S. payee provides a Form W-9 to the payor or where the U.S. payee is an exempt recipient such as a corporation, tax-exempt organization or governmental entity.

50 Id. 51 New Code Sec. 1474(a); “Technical Expla-

nation of H.R. 4213, the Tax Extenders Act of 2009,” prepared by the Staff of the Joint Committee on Taxation (hereinafter referred to as Staff of the Joint Committee Techni-cal Explanation for the Extenders Act”), at 137.

52 Reg. §1.1461-1(a) and 1(b).

53 Code Sec. 1461.54 Reg. §1.1461-1(e).55 DuPont Glore Forgan Inc. v. American Tele-

phone & Telegraph Co., DC-NY, 77-1 usTC ¶16,256, 428 FSupp 1297 (1977).

56 U.S. Withholding and Reporting Require-ments for Payments of U.S. Source Income to Foreign Persons, Tax ManageMenT PorTFolio 915-2nd (hereinafter cited as “Tax Manage-ment Portfolio 915-2nd”), at A-126; Dale, Withholding Tax on Payments to Foreign Per-sons, 36 Tax l. rev. 49, at 98–99 (1980).

57 Synthetic Patents Co. v. Sutherland, 22 F2d 491 (2nd Cir. 1927), cert. denied, 276 US 630 (1928).

58 A. Gusmer, Inc. v. McGrath, CA-DC, 52-1 usTC ¶9297, 196 F2d 860 (1952), cert. denied, 344 US 831 (1952).

59 McGrath v. Dravo Corp, CA-3, 50-2 usTC ¶9422, 183 F2d 709 (1950).

60 Reg. §1.1464-1(a). 61 Reg. §1.1441-3(d)(1).62 Id.63 Id.64 Code Sec. 6302; Reg. §1.6302-2(a). 65 Form 8109, a coupon book with 15 deposit

forms, is sent to the withholding agent at the end of each year. A withholding agent will not be excused from making a deposit (or from the resulting penalties) by the fact that no form has been furnished to it. Ap-plications for this form may be made to the district director of a service center. See Tax Management Portfolio 915-2nd, at A-134.

66 Reg. §1.6302-2.67 Reg. §1.1461-1(a)(1).68 Id.; Tax Management Portfolio 915-2nd, at

A-134. 69 Int’l Sleeping Car. Co., 14 BTA 702, Dec.

4654 (1928). Under Code Sec. 6316, the Treasury has authority to allow payment of taxes to be made in foreign currency. However, the regulations allow payment of taxes in a foreign currency only with re-spect to amounts received by a U.S. citizen in nonconvertible foreign currency out of funds made available to a foreign founda-tion for financing study and research abroad under the Mutual Educational and Cultural Exchange Act or under certain other acts. Reg. §301.6316-1. See Tax Management Portfolio 915-2nd, at A-135.

70 Reg. §1.1441-3(e)(2).71 Id.; Tax Management Portfolio 915-2nd, at

A-135.72 See Tax Management Portfolio 915-2nd, at

A-117; Reg. §1.1441-1(b)(7)(i). 73 See Tax Management Portfolio 915-2nd, at

A-7.74 Tax Management Portfolio 915-2nd, at

A-118; Reg. §1.1441-1(b)(7)(iii).75 Rev. Rul. 72-173, 1972-1 CB 282.76 Reg. §1.1441-7(a)(1).77 Tax Management Portfolio 915-2nd, at

A-117.78 New Code Sec. 1471(a).


July 2010

79 New Code Sec. 1473(4); Staff of the Joint Committee Technical Explanation for the Extenders Act, at 133; Reg. §1.1441-7(a) defines a “withholding agent” broadly to include any U.S. or foreign person that has the control, receipt, custody, disposal or payment of an item of income of a foreign person subject to withholding.

80 New Code Sec. 1471(a). 81 Technical Explanation of the Revenue

Provisions Contained in the Senate Amend-ment 3310, the ‘Hiring Incentives to Re-store Employment Tax under Consideration by the Senate (JCX-4-10) (hereinafter “JCT Explanation”).

82 Id., at 80. 83 Reg. §1.1441-7(a)(1).84 Id.85 Tax Management Portfolio 915-2nd, at

A-117.86 Id.87 Id.88 “Comments on Foreign Account Tax Com-

plaince Act Provisions Incorporated in the Hiring Incentives to Restore Employment Act (‘FATCA’),” submitted by the European Banking Federation and Institute of Inter-national Bankers to the Treasury (April 23, 2010) (hereinafter referred to as “EBF/IIB Comments”), at 22.

89 Sullivan & Cromwell FATCA Comments, at 4.

90 Reg. §1.1441-1(b)(2).91 Reg. §1.1441-1(b)(2)(i).92 Reg. §1.1441-1(b)(2)(iii)(A); Reg. §301.7701-

2(c)(1), (2)93 Tax Management Portfolio 915-2nd, at

A-10.94 Reg. §1.1441-1(b)(2); Proposed Reg. §1.702-

1(a)(8)(ii), Code §865)(i)(5).95 Reg. §1.1441-1(b)(2)(iii)(B).96 Id., Tax Management Portfolio 915-2nd, at

A-11.97 Reg. §1.1441-5(c)(1)(i).98 Id.99 Reg. §1.1441-5(d)(1)(ii)(B) and (C).100 New Code Sec. 1473(1)(A)(i); Staff of the

Joint Committee Technical Explanation for the Extenders Act, at 133.

101 New Code Sec. 1473(1)(A)(ii); Staff of the Joint Committee Technical Explanation for the Extenders Act, at 133.

102 Id.103 New Code Sec. 1473(l)(A)(ii); Staff of the


104 Code Sec. 1445.105 Staff of the Joint Committee Technical Expla-

nation for the Extenders Act, at 133. See Act Sec. 541 of the Extenders Act.

106 Latham & Wilkins Client Alert entitled For-eign Account Tax Compliance Act of 2009 Introduced in Congress, at 1–2.

107 IRM §4.10.21.1.1.108 Reg. §1.1441-2. 109 Reg. §§1.1441-2(b)(1)(i), -2(b)(2); Rev. Rul.

2004-75, 2004-2 CB 109 (holding that the income of a nonresident alien individual under a life insurance or annuity contract issued by a foreign branch of a U.S. life insurance company is FDAP income from U.S. sources); Rev. Rul. 2004-97, 2004-2 CB 516 (stating that Rev. Rul. 2004-75 does not apply to payments made before January 1, 2005, pursuant to binding life insurance or annuity contracts issued by a foreign branch on or before July 12, 2004). However, gain on a sale or exchange of Code Sec. 306(a) treats the gain as ordinary income. Reg. §1.306-3(h).

110 Code Sec. 861(a); Reg. §1.861-2(a)(1). In-terest paid by the U.S. branch of a foreign corporation is also treated as U.S. source interest under Code Sec. 884(f)(1).

111 Code Secs. 861(a)(2), 862(a)(2). 112 Code Sec. 861(a)(4).113 Id.114 See “Technical Explanation of the Foreign

Account Tax Compliance Act of 2009,” prepared by the Staff of the Joint Committee on Taxation on October 27, 2009 (JCX-42-09) (hereinafter referred to as Staff of the Joint Committee Technical Explanation for FATCA”), at 3.

115 Code Sec. 861(a)(a)(B); Reg. §1.1441-1(b)(4)(iii).

116 Code Secs. 871(i)(2)(A), 881(d); Reg. §1.1441-1(b)(4)(ii). If the bank deposit is effectively connected with a U.S. trade or business, it is subject to regular U.S. income tax rather than withholding tax.

117 Code Secs. 871(g)(1)(B), 881(a)(3); Reg. §1.1441-1(b)(4)(iv).

118 Reg. §1.461-1(c)(2)(ii)(A), (B). 119 New Code Sec. 1473(1)(C); Staff of the Joint

Committee Technical Explanation for the Extenders Act, at 134.

120 ABA Tax Section Comments, at 16–17. 121 ABA Tax Section Comments footnote, at

16, “We do not believe simply defining the amount as U.S. source income would be meaningful, except in the much smaller subset of cases in which a conduit arrange-ment exists.

122 Under Code Sec. 7701(l), Treasury may prescribe regulations recharacterizing any multiple-party financing transaction as a transaction directly among any two or more of such parties where the Treasury determines that such recharacterization is appropriate to prevent the avoidance of tax.

123 Code Secs. 871(h), 881(c). Congress be-lieved that the imposition of a withholding tax on portfolio interest paid on debt obliga-tions issued by U.S. persons might impair the ability of domestic corporations to raise capital in the Eurobond market (i.e., the global market for U.S. dollar-denominated debt obligations). Congress also anticipated that repeal of the withholding tax on portfo-lio interest would allow the Treasury direct

access to the Eurobond market. See Staff of the Joint Committee Technical Explanation for the Extenders Act, at 112.

124 Code Sec. 871(h)(3). A 10-percent share-holder includes any person who owns 10 percent or more of the total combined voting owner of all classes of stock of the corpora-tion (in the case of a corporate obligor), or 10 percent or more of the capital or profits interest of the partnership (in the case of a partnership obligor). The attribution rules of Code Sec. 318 apply for this purpose, with certain modifications.

125 Code Sec. 871(h)(4). Contingent interest generally includes any interest if such in-terest is determined by reference to any re-ceipts, sales or other cash flow of the debtor or a related person; any income or profit of the debtor or a related person; any change in the value of any property of the debtor or a related person; any dividend, partner-ship distributions or similar payments made by the debtor or a related person; and any other type of contingent interest identified by Treasury regulation. Certain exceptions also apply.

126Code Sec. 881(c)(3)(C). A related person includes, among other things, an indi-vidual owning more than 50 percent of the stock of the corporation by value, a corporation that is a member of the same controlled group (defined using a 50-percent common ownership test), a partnership if the same persons own more than 50 percent in value of the stock of the corporation and more than 50 percent of the capital interests in the partnership, any U.S. shareholder (as defined in Code Sec. 951(b) and generally including any U.S. person who owns 10 percent or more of the voting stock of the corporation), and certain persons related to such a U.S. shareholder.

127 Code Sec. 881(c)(3)(A). 128 ABA Tax Section Comments, at 7. 129 ABA Tax Section Comments, at 7.130 Code Sec. 871(a)(2). In most cases, however,

an individual satisfying this presence test will be treated as a U.S. resident under Code Sec. 7701(b)(3), and thus will be subject to full residence-based U.S. income taxation.

131 Code Secs. 881(a), 631(b) and (c). 132 New Code Sec. 1473(l)(A)(ii); Staff of the


133 Staff of the Joint Committee Technical Expla-nation for the Extenders Act, at 133. See Act Sec. 541 of the Extenders Act.

134 “Description of Revenue Provisions Con-tained in the Fiscal Year 2010 Budget Proposal” prepared by the Staff of the Joint Committee on Taxation (September 2009) (hereinafter termed “Staff of the Joint Com-mittee Explanation of President’s Budget Proposal,”) at 183.

135 ABA Tax Section Comments, at 17.

88


136 Code Sec. 871(b)(1) provides that a nonresi-dent alien individual engaged in a trade or business within the United States during the tax year shall be taxable as effectively con-nected with the conduct of a trade or business within the United States.

137 Code Sec. 882(a)(1) provides a foreign cor-poration engaged in trade or business within the United States during the tax year shall be taxable on its taxable income which is effectively connected with the conduct of a trade or business within the United States.

138 New Code Sec. 1473(1)(B); Staff of the Joint Committee Technical Explanation for the Extenders Act, at 133.

139 Code Sec. 887(b) provides that U.S. gross transportation income does not include any income taxable under Code Sec. 871(b) or 882.

140 New Code Sec. 1473(l); Staff of the Joint Com-mittee Technical Explanation for the Extenders Act, at 133.

141 EBF/IIB Comments, at 21. 142 On November 19, 2009 the Securities

Industry and Financial Markets Association (hereinafter, “SIFMA”) submitted comments entitled, “Comments on the Foreign Account Tax Compliance Act of 2009,” to the House Ways and Means Select Revenue Measures Subcommittee (hereinafter termed, “SIFMA Comments”); see SIFMA Comments, at 10.

143 Compare Act Sec. 1472(c)(2) with Act Sec. 1471(f)(4) of FACTA and the new law.

144 Id.145 New Code Sec. 1471(b)(1)(A).146 New Code Sec. 1471(b)(1)(C).147 New Code Sec. 1471(b)(1)(B). 148 New Code Sec. 1471(b)(1)(E).149 New Code Sec. 1471(b)(1)(F).150 New Code Sec. 1471(b)(1)(D).151 EBF/IIB Comments, at 16–17.152 EBF/IIB Comments, at 17. 153 Testimony of Tom Prevost, the Americas Tax

Director for Credit Suisse to the House Ways and Means Subcommittee on Select Revenue Measures on November 5, 2009 (hereinafter termed, “Credit Suisse Comments”), at 5.

154 Footnote 3 of Credit Suisse Comments provides, “If FFIs are allowed to use their anti money laundering (‘AML’)/ know-your-customer (‘KYC’) procedures for determining U.S. owners of foreign entities as we have suggested, changes in ownership should also be determined based on the FFIs AML/KYC procedures.”

155 European Banking Federation and the Institute of International Bankers submitted comments to the U.S. House Ways and Means Com-mittee on the proposed FATCA legislation (hereinafter referred to as “EBF FATCA Com-ments”).

156 EBF FATCA Comments footnote 2 provides, “In practice, many investors may not take the affirmative steps to maintain their U.S. investments due to deference to the recom-mendations of their investment advisers, in-

ertia or other reasons. One of the unfortunate consequences of this new regime, which may contribute to such capital flow shifts, is that it will result in withholding tax on payments to a beneficial owner who fully complies with the U.S. tax rules (e.g., by providing a W-8BEN to a QI in which he/she holds an account) if any entity in the chain of FFIs through which it invests in U.S. securities fails to enter into an FFI agreement. Many investors may regard the prospect of eventually receiving a refund if the investor files, and is able to substantiate, a claim as more theoretical than real.”

157 EBF FATCA Comments footnote 3 provides, “Depending on the country, the applicable KYC and AML rules and account opening procedures do require that an FFI obtain infor-mation concerning an entity account holder’s substantial owners that would be useful for U.S. tax compliance, although typically the thresholds are above the 0 percent threshold for U.S. owners of foreign investment entities and a 10 percent threshold for other entities, and these rules and procedures generally are focused on the identity of the owner rather than the person’s tax status.”

158 EBF FATCA Comments footnote 4 provides, “We acknowledge that one potential chal-lenge in successfully applying a Section 1472 regime to tiers of FFIs may be a reluctance of one FFI to disclose its customer (or investor) base to another; similar concerns contributed to the development of the QI system. Giving FFIs a choice between a Section 1471 or 1472 regime may mitigate this challenge.”

159 NYSBA Tax Section Comments, at 8–9.160 Act Sec. 101 of FATCA (formerly designated as

Act Sec. 1471(c)(3)); see also Staff of the Joint Committee Technical Explanation for FATCA, at 18.

161 SIFMA Comments, at 6.162 SIFMA Comments, at 6, footnote 15, provides,

“For example, the sharing of relevant informa-tion may be prohibited under the so-called ‘Chinese Walls’ required under U.S. securi-ties laws. See, e.g., 15 USC §78o(f) (2006) (requiring broker-dealers to adopt policies and procedures designed to prevent insider trading and tipping); 15 USC §80b-4a (2006) (requiring investment advisors to establish policies and procedures reasonable designed to prevent insider trading and tipping).”

163 New Code Sec. 1471(b)(1)(F).164 Chris Kentouris, Curbing Tax Evasion: Do You

Know Where Your Data Is? seCuriTies indusTrY news, Jan. 25, 2010.

165 ABA Tax Section Comments, at 15–16. 166 A foreign financial institution willing to de-

posit withholding tax should not be required to terminate the account of a person (though, if cooperation is refused, that surely will hap-pen without action by the institution).

167 New Code Sec. 1471(b)(3). Comments dated December 11, 2009, provided by Sullivan & Cromwell LLP entitled “Revised FATCA plus Carried Interest Taxation” (hereinafter termed

“Sullivan & Cromwell Comments”), at 4.168 New Code Sec. 1471(d)(7); Staff of the Joint

Committee Technical Explanation for the Ex-tenders Act, at 133. According to comments dated December 11, 2009, provided by Sulli-van & Cromwell LLP entitled “Revised FATCA Plus Carried Interest Taxation,” (hereinafter termed “Sullivan & Cromwell Comments”), at 4, footnote 4, and provided [A] passthrough payment could potentially include an amount of foreign-source income, such as a dividend payment that is attributable to U.S. source interest There is no legislative gloss on what is means for a payment to be “attributable” to a withholdable payment.”

169 Id.170 New Code Sec. 1471(b)(1)(D); James N.

Calvin, Foreign Investment Vehicles and the New Foreign Account Tax Compliance Rules of the HIRE Act, 10 dailY Tax reP. 59 (Mar. 30, 2010) (hereinafter cited as “Calvin Article”), at 3.

171 Calvin Article, at 3. 172 EBF/IBB Comments at 14-15.173 Matthew Blum, Comments on “Passthrough

Payments” issues under FATCA, (May 3, 2010), hereinafter cited as “Blum Comments.”

174 JCT Explanation, at 40. 175 Id.176 Id. 177 Staff of the Joint Committee Technical Expla-

nation for the Extenders Act, at 130.178 New Code Sec. 1471(b)(3)(B). 179 Staff of the Joint Committee Technical Expla-

nation for the Extenders Act, at 130.180 EBF/IIB Comments, at 18.181 Blum Comments.182 EBF/IIB Comments, at 18.183 New Code Sec. 1471(d)(7); Staff of the Joint

Committee Technical Explanation for the Ex-tenders Act, at 133. According to comments dated December 11, 2009, provided by Sulli-van & Cromwell LLP entitled “Revised FATCA Plus Carried Interest Taxation,” (hereinafter termed “Sullivan & Cromwell Comments”), at 4, footnote 4, and provided [A] passthrough payment could potentially include an amount of foreign-source income, such as a dividend payment that is attributable to U.S. source interest There is no legislative gloss on what is means for a payment to be “attributable” to a withholdable payment.”

184 Id.185 Id.186 Id.187 Id.188 Id.189 EBF/IIB Comments, at 15.190 New Code Sec. 1471(d)(6)(A); Staff of the


191 New Code Sec. 1471(d)(6)(B); Staff of the Joint Committee Technical Explanation for the Extenders Act, at 133.

192 New Code Sec. 1471(d)(6)(B); The new law keeps the provision included in FATCA that


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requires foreign financial institutions to close accounts maintained by account holders who refuse to provide a waiver of an applicable provision of foreign law that prohibits infor-mation reporting within a reasonable period of time.

193 New Code Sec. 1471(b)(3)(C).194 New Code Sec. 1471(b)(3)(C)(i); Staff of the


195 Blum Comments, at 1–2.196 New Code Sec. 1471(b)(3)(C)(ii). 197 New Code Sec. 1471(b)(3)(C).198 NYSBA Tax Comments, at 9.199 New Code Sec. 1471(b). 200 New Code Sec. 1471(e)(1)(A) and (B). 201 Sullivan & Cromwell FATCA Comments, at

6. 202 Id.203 Sullivan & Cromwell Comments, at 6, foot-

note 10. 204 New Code Sec. 1471(e)(2)(A) and (B). Code

Sec. 1504 (a) and (b) provides that the term “affiliated group” means one or more chains of includible corporations connected through stock ownership with a common parent cor-poration if the common parent owns at least 80 percent of the total voting power and value of such includible corporations.

205 Code Sec. 1504(b)(3) provides that an includ-ible corporation does not include a foreign corporation.

206 New Code Sec. 1471(e)(2); Staff of the Joint Committee Technical Explanation for the Extenders Act, at 133.

207 Id. 208 Code Sec. 954(d)(3)(A).209 Code Sec. 954(d)(3)(B).210 Code Sec. 954(d)(3). 211 Id.212 Staff of the Joint Committee Technical Expla-

nation for the Extenders Act, at 129. 213 The U.S. know-your-customer rules are

primarily found in the Bank Secrecy Act of 1970 and in Title III, The International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001 of the USA PATRIOT Act.

214 The term “financial institution” is broadly defined under 31 USC §5312(a)(2) or (c)(1) and includes U.S. banks and agencies or branches of foreign banks doing business in the United States, insurance companies, credit unions, brokers and dealers in securities or commodities, money services businesses and certain casinos.

215 “Relevant risks” include the types of accounts held at the financial institution; the methods available for opening accounts; the types of customer identification information available; and the size, location and customer base of the financial institution. 31 CFR §103.121(b)(2).

216 For a person other than an individual the address is the principal place of business, lo-cal office or other physical location. 31 CFR

§103.121(b)(2)(i)(3)(iii).217 For a U.S. person, the identification number is

the TIN. For a non-U.S. person, the identifica-tion number could be a TIN, passport number, alien identification number or number and country of issuance of any other government-issued document evidencing nationality or residence and bearing a photograph or similar safeguard. 31 CFR §103.121(b)(2)(i)(4).

218 31 CFR §103.121(b)(2).219 For example, a financial institution is not “re-

quired to look through trust, escrow, or similar accounts to verify the identities of beneficia-ries and instead will only be required to verify the identity of the named account holder.” 68 FR 25,090, 25,094 (May 9, 2003).

220 31 CFR §103.121(b)(2)(ii)(C).221 In order to assess the risk of the account rela-

tionship, a financial institution may need to ascertain the type of business, the purpose of the account, the source of the account funds and the source of the wealth of the owner or beneficial owner of the entity.

222 31 CFR §103.178. A private banking account is an account that (1) requires a minimum deposit of not less than $1 million; (2) is established for the benefit of one or more non-U.S. persons who are direct or beneficial owners of the account; and (3) is administered or managed by an officer, employee or agent of the financial institution. Beneficial owner for these purposes is defined as an individual who has a level of control over, or entitlement to the funds or assets in the account. 31 CFR §§103.175(b), 103.175(o).

223 The European Union (EU) Third Money Laundering Directive 1 (Directive 2005/60/EC of the European Parliament and of the Council, October 26, 2005 (“EU Third Money Laundering Directive”) is also applicable to a broad range of persons including credit institutions and financial institutions as well as to persons acting in the exercise of certain professional activities. The directive applies to auditors, accountants, tax advisors, notaries, legal professionals, real estate agents, certain persons trading in goods (cash transactions in excess of EUR 15,000) and casinos). It requires systems, adequate policies and pro-cedures for customer due diligence, report-ing, record keeping, internal controls, risk assessment, risk management, compliance management and communication. Required customer due diligence measures go further than the know-your-customer rules in the United States in requiring identification and verification of the beneficial owner and an understanding of the ownership and control structure of the customer in addition to the basic customer identification program and customer due diligence requirements. A “beneficial owner” is defined as the natural person who ultimately owns or controls the customer and/or the natural person on whose behalf a transaction or activity is being con-ducted. For corporations, beneficial owner

includes (1) the natural person or persons who ultimately owns or controls a legal entity through direct or indirect ownership or con-trol over a sufficient percentage (25 percent plus one share) of the shares or voting rights in that legal entity; and (2) the natural person or persons who otherwise exercises control over the management of the legal entity (EU Third Money Laundering Directive Art. 3(6)(a)). Inquiries into beneficial ownership gener-ally may stop at the level of any owner that is a company listed on a regulated market. For foundations, trusts, and like entities that administer and distribute funds, beneficial owner includes (1) in cases in which future beneficiaries are determined, a natural person who is the beneficiary of 25 percent or more of the property; (2) in cases in which future beneficiaries have yet to be determined, the class of person in whose main interest the legal arrangement is set up or operates; and (3) natural person who exercises control over 25 percent or more of the property (EU Third Money Laundering Directive Art. 3(6)(b)). Under the EU Third Money Laundering Directive, EU member states generally must require identification of the customer and any beneficial owners before the establish-ment of a business relationship (EU Third Money Laundering Directive Art. 9).The EU Third Money Laundering Directive requires ongoing account monitoring including scru-tiny of transactions throughout the course of relationship to ensure that the transactions conducted are consistent with the customer and the business risk profile. It requires docu-ments and other information to be updated and requires performance of customer due diligence procedures at appropriate times (such as a change in account signatories or change in the use of an account) for existing customers on a risk sensitive basis. Records must be maintained for up to five years after the customer relationship has ended.

224 The regulations under Code Sec. 1441 spe-cifically address certification, documentation, withholding and reporting of payments to U.S. and foreign persons through foreign financial institutions (FFIs). FFIs may contract with the IRS to operate according to a set of withhold-ing and reporting rules under the so-called qualified intermediary (QI) program. QIs agree to collect identifying documentation from their customers, file withholding tax returns and information returns, and submit to periodic audits performed by external auditors supervised by IRS examiners. QIs may furnish a withholding certificate to a withholding agent in lieu of transmitting to the withholding agent documentation for persons for whom the QI receives the payment and, in the case of U.S. non-exempt recipients, may assume primary Form 1099 reporting and backup withholding responsibility. If a QI assumes primary Form 1099 reporting and backup withholding responsibility with respect to

90


accounts held by U.S. persons, such report-ing may be limited to certain income earned through those accounts. Further, a QI that assumes primary Form 1099 reporting and back-up withholding responsibility with re-spect to U.S. persons is not required to assume that responsibility for all accounts. Moreover, in the case of financial institutions that are part of a controlled group, one member of the controlled group may contract to be a QI while other members of the controlled group do not, and thus accounts and clients may be divided between commonly controlled QI and non-QI institutions.

225 Staff of the Joint Committee Explanation of President’s Budget Proposal, at 176.

226 For purposes of the FDAP withholding tax rules, a “beneficial owner” is defined as the person that is the owner of the income for U.S. tax purposes. Reg. §1.1441-1(c)(6)(ii)(B). The beneficiaries of a foreign simple or grantor trust are generally considered to be the ben-eficial owners of income paid to such trust. Reg. §1.1441-1(c)(6)(ii)(C). A foreign estate or foreign complex trust is treated for these purposes as the beneficial owner of income paid to such trust or estate. Reg. §1.1441-1(c)(6)(ii)(D).

227 Reg. §1.6049-5(c)(4). 228 For example, most states in the United States

do not require companies to report ultimate ownership either at the time of the initial formation of the company or in periodic filings by the company. On the other end of the spectrum are the Crown Dependen-cies which generally require disclosure and periodic updates of company ownership. See Government Accountability Office, Company Formations, Minimal Ownership Is Collected and Available, GAO-06-376 (Apr. 2006).

229 For example, the United States and other non-EU jurisdictions could adopt rules consistent with the European Union’s Third Anti–money laundering Directive, 2005/60/EC, which generally requires identification of any natural persons who own more than 25 percent of a legal entity account holder.

230 Staff of the Joint Committee Technical Expla-nation for FATCA.

231 In general, under the QI agreement, the QI must permit the external auditor to have access to all records of the QI, including information regarding specific account hold-ers. In addition, the QI must permit the IRS to communicate directly with the external audi-tor, review the audit procedures followed by the external auditor and examine the external auditor’s work papers and reports. In addition, to the external audit requirements set forth in the QI agreement, the IRS has issued further guidance (“the QI audit guidance”) for an external auditor engaged by a QI to verify the QIs compliance with the QI agreement. Rev. Proc. 2002-55, 2002-2 CB 435. An external auditor must conduct its audit in accordance with the procedures described in the QI

agreement. However, the QI audit guidance is intended to assist the external auditor in understanding and applying those proce-dures. The QI audit guidance does not amend, modify or interpret the QI agreement.

232 Credit Suisse Comments, at 8.233 Id. 234 ABA Tax Section Comments, at 15.235 Staff of the Joint Committee Technical Expla-

nation for the Extenders Act, at 129. 236 Id. 237 New Code Sec. 1471(b)(2)(A). 238 EBF/IIB Comments, at 6–7. 239 Id.240 Id.241 Id. The legislative history has identified certain

controlled foreign corporations owned by U.S. financial institutions and certain U.S. branches of foreign financial institutions that are treated as U.S. payors under the Code as exempt from the requirements of new Code Sec. 1471(b), provided such institutions are subject to similar due diligence and report-ing requirements under other provisions of the Code. Presumably, the legislative history leaves room for the Treasury to identify other legal entities and institutions who are exempt based on the same rationale.

242 ABA Tax Section Comments, at 10–11.243 New Code Sec. 1471(f); Staff of the Joint Com-

mittee Technical Explanation for the Extenders Act, at 133.

244 New Code Sec. 1471(f)(1); Staff of the Joint Committee Technical Explanation for the Extenders Act, at 133.

245 Id. 246 Id. 247 New Code Sec. 1471(f)(2); Staff of the Joint




250 EBF/IIB Comments, at 4.251 JCT Report, at 46. 252 New Code Sec. 1471(c)(1).253 New Code Sec. 1471(c)(1)(A).254 Id.255 New Code Sec. 1471(c)(1)(B).256 New Code Sec. 1471(c)(1)(C).257 New Code Sec. 1471(c)(1)(D). 258 New Code Sec. 1471(c)(1); Staff of the Joint


259 Id.260 Id. 261 Act Sec. 801 of the HIRE Act; New Code Sec.

1471(c)(1)(D). 262 EBF/IIB Comments, at 18–19.263 EBF FATCA Comments.264 Reg. §1.1461-1(b)(1).265 Id.266 Id.

267 Reg. §1.1461-1(c)(3); Tax Management Port-folio 915-2nd, at 130–31.

268 NYSBA Tax Comments, at 4–5. 269 ABA Tax Section Comments, at 12. 270 New Code Sec. 1471(c)(2)(B)(i) and (ii).271 Staff of the Joint Committee Technical Expla-

nation for the Extenders Act, at 131.272 New Code Sec. 1471(c)(2). 273 Staff of the Joint Committee Technical Expla-

nation for the Extenders Act, at 131.274 See Foreign Account Tax Compliance Act of

2009, Tax TransaCTions uPdaTe, Mayer Brown, Nov. 16, 2009.

275 EBF/IIB Comments, at 20. 276 Id.277 SIFMA Comments, at 9. 278 Id. 279 New Code Sec. 1471(c)(3); Staff of the Joint


280 The definition also includes: a foreign branch or office of a U.S. financial institution or U.S. clearing organization; a foreign corporation for purposes of presenting income tax treaty claims on behalf of its shareholders; and any other person acceptable to the IRS, in each case that such person has entered into a withholding agreement with the IRS. Reg. §1.1441-1(e)(5)(ii).

281 U.S. withholding agents are allowed to rely on a QI’s Form W-8IMY without any underlying beneficial owner documentation. By contrast, nonqualified intermediaries are required both to provide a Form W-8IMY to a U.S. withhold-ing agent and to forward with that document Forms W-8 or W-9 or other specified docu-mentation for each beneficial owner.

282 Rev. Proc. 2000-12, 2000-1 CB 387, QI agree-ment §§2.12, 5.03, 6.01.

283 Rev. Proc. 2000-12, 2000-1 CB 387, supple-mented by Announcement 2000-50, 2000-1 CB 998, and modified by Rev. Proc. 2003-64, 2003-2 CB 306, and Rev. Proc. 2005-77, 2005-2 CB 1176. The QI agreement applies only to foreign financial institutions, foreign clearing organizations, and foreign branches or offices of U.S. financial institutions or U.S. clearing organizations. However, the principles of the QI agreement may be used to conclude agreements with other persons defined as QIs.

284 Rev. Proc. 2000-12, 2000-1 CB 387, QI agree-ment §3.02.

285 Regardless of whether a QI assumes primary Form 1099 reporting and backup withholding responsibility, the QI is responsible for Form 1099 reporting and backup withholding on certain reportable payments that are not reportable amounts. See Rev. Proc. 2000-12, 2001-1 CB 387, QI agreement §§2.43 (defining reportable amount), 2.44 (defining reportable payment), 3.05, 8.04. The reporting responsibility differs depending on whether the QI is a U.S. payor or a non-U.S. payor. Ex-amples of payments for which the QI assumes primary IRS Form 1099 reporting and backup


July 2010

withholding responsibility include certain broker proceeds from the sale of certain assets owned by a U.S. non-exempt recipient and payments of certain foreign-source income to a U.S. non-exempt recipient if such income is paid in the United States or to an account maintained in the United States.

286 To the extent that a QI assumes primary re-sponsibility for an account, it must do so for all payments made by the withholding agent to that account. See Rev. Proc. 2000-12, QI agreement §3.

287 A QI agrees to use its best efforts to obtain documentation regarding the status of their account holders in accordance with the terms of its QI agreement. A QI must apply presumption rules unless a payment can be reliably associated with valid documentation from the account holder. The QI agrees to adhere to the know-your-customer rules set forth in the QI agreement with respect to the account holder from whom the evidence is obtained. See Rev. Proc. 2000-12, QI agree-ment §5. The QI agreement contains its own presumption rules. See Rev. Proc. 2000-12, QI agreement §5.13(C). An amount subject to withholding that is paid outside the United States to an account maintained outside the United States is presumed made to an undocumented foreign account holder (i.e., subject to 30-percent withholding). Payments of U.S. source deposit interest and certain other U.S. source interest and original issue discount paid outside of the United States to an offshore account is presumed made to an undocumented U.S. nonexempt account holder (i.e., subject to backup withholding). For payments of foreign source income, broker proceeds and certain other amounts, the QI can assume such payments are made to an exempt recipient if the amounts are paid outside the United States to an account maintained outside the United States.

A QI may treat an account holder as a foreign beneficial owner of an amount if the account holder provides a valid Form W-8 (other than a Form W-8IMY) or valid docu-mentary evidence that supports the account holder’s status as a foreign person. (Documen-tary evidence is any documentation obtained under know-your-customer rules per the QI agreement, evidence sufficient to establish a reduced rate of withholding under Reg. §1.1441-6, and evidence sufficient to estab-lish status for purposes of Chapter 61 under Reg. §1.6049-5(c). See Rev. Proc. 2000-12, QI agreement §2.12.) With such documentation, a QI generally may treat an account holder as entitled to a reduced rate of withholding if all the requirements for the reduced rate are met and the documentation supports entitlement to a reduced rate. A QI may not reduce the rate of withholding if the QI knows that the account holder is not the beneficial owner of a payment to the account. If a foreign account holder is the beneficial owner of a

payment, then a QI may shield the account holder’s identity from U.S. custodians and the IRS. If a foreign account holder is not the beneficial owner of a payment (for example, because the account holder is a nominee), the account holder must provide the QI with a Form W-8IMY for itself along with specific information about each beneficial owner to which the payment relates.

A QI that receives this information may shield the account holder’s identity from a U.S. custodian, but not from the IRS. (This rule restricts one of the principal benefits of the QI regime, nondisclosure of account holders, to financial institutions that have assumed the documentation and other obli-gations associated with QI status.) In general, if an account holder is a U.S. person, the account holder must provide the QI with a Form W-9 or appropriate documentary evidence that supports the account holder’s status as a U.S. person. However, if a QI does not have sufficient documentation to determine whether an account holder is a U.S. or foreign person, the QI must apply certain presumption rules detailed in the QI agreement. These presumption rules may not be used to grant a reduced rate of nonresident withholding; instead, they merely determine whether a payment should be subject to full nonresident withholding (at a 30-percent rate), subject to backup withholding (at a 28-percent rate), or treated as exempt from backup withholding. In general, under the QI agreement presumptions, U.S.-source investment income that is paid outside the United States to an offshore account is presumed to be paid to an undocumented foreign account holder. A QI must treat such a payment as subject to withholding at a 30-percent rate and report the payment to an unknown account holder on Form 1042-S. However, most U.S.-source deposit interest and interest or original issue discount on short-term obligations that is paid outside the United States to an offshore account is presumed made to an undocumented U.S. nonexempt recipient account holder and thus is subject to backup withholding at a 28-percent rate. (These amounts are statutorily exempt from nonresident withholding when paid to non-U.S. persons.) Importantly, both foreign-source income and broker proceeds are presumed to be paid to a U.S. exempt recipient (and thus are exempt from both nonresident and backup withholding) when such amounts are paid outside the United States to an offshore account.

A QI must file Form 1042 by March 15 of the year following any calendar year in which the QI acts as a QI. A QI is not required to file Forms 1042-S for amounts paid to each separate account holder, but instead files a separate Form 1042-S for each type of reporting pool. (A reporting pool consists of income that falls within a particular with-

holding rate and within a particular income code, exemption code, and recipient code as determined on Form 1042-S.) A QI must file separate Forms 1042-S for amounts paid to certain types of account holders, including (1) other QIs that receive amounts subject to foreign withholding; (2) each foreign ac-count holder of a nonqualified intermediary or other flow-through entity to the extent that the QI can reliably associate such amounts with valid documentation; and (3) unknown recipients of amounts subject to withholding paid through a nonqualified intermediary or other flow-through entity to the extent the QI cannot reliably associate such amounts with valid documentation. Form 1042 must also include an attachment setting forth the ag-gregate amounts of reportable payments paid to U.S. non-exempt recipient account holders and the number of such account holders, whose identity is prohibited by foreign law (including by contract) from disclosure. (For undisclosed accounts, QIs must separately report each type of reportable payment (de-termined by reference to the types of income reported on Forms 1099) and the number of undisclosed account holders receiving such payments.)

A QI has specified on Form 1099 (if the QI is required to file IRS Forms 1099, it must file the appropriate form for the type of income paid (e.g., Form 1099-DIV for dividends, Form 1099-INT for interest, and Form 1099-B for broker proceeds) filing requirements including (1) filing an aggre-gate Form 1099 for each type of reportable amount paid to U.S. nonexempt recipient account holders whose identities are pro-hibited by law from being disclosed; (2) fil-ing an aggregate Form 1099 for reportable payments other than reportable amounts (the term “reportable amount” generally includes those amounts that would be re-ported on Form1042-S if the amount were paid to a foreign account holder; the term “reportable payment” generally refers to amounts subject to backup withholding, but it has a different meaning depend-ing upon the status of the QI as a U.S. or non-U.S. payor) paid to U.S. nonexempt recipient account holders whose identities are prohibited by law from being disclosed; (3) filing separate Forms 1099 for reportable amounts paid to U.S. non-exempt recipi-ent account holders for whom the QI has not provided an Form W-9 or identifying information to a withholding agent; (4) filing separate Forms 1099 for reportable payments other than reportable amounts paid to U.S. non-exempt recipient ac-count holders; (5) filing separate Forms 1099 for reportable amounts paid to U.S. nonexempt recipient account holders for which the QI has assumed primary Form 1099 reporting and backup withholding responsibility; and (6) filing separate

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Forms 1099 for reportable payments to an account holder that is a U.S. person if the QI has applied backup withholding and the amount was not otherwise reported on an Form 1099. The QI agreement in-cludes procedures to address situations in which foreign law (including by contract) prohibits the QI from disclosing the identi-ties of U.S. non-exempt recipients (such as individuals). Separate procedures are provided for accounts established with a QI prior to January 1, 2001, and for ac-counts established on or after January 1, 2001.

Accounts established prior to January 1, 2001: For accounts established prior to January 1, 2001, if the QI knows that the account holder is a U.S. non-exempt recipient, the QI must (1) request from the account holder the authority to disclose its name, address, TIN (if available) and report-able payments; (2) request from the account holder the authority to sell any assets that generate, or could generate, reportable payments; or (3) request that the account holder disclose itself by mandating the QI to provide an IRS Form W-9 completed by the account holder. The QI must make these requests at least two times during each calendar year and in a manner consistent with the QI’s normal communications with the account holder (or at the time and in the manner that the QI is authorized to com-municate with the account holder). Until the QI receives a waiver on all prohibitions against disclosure, authorization to sell all assets that generate, or could generate, reportable payments, or a mandate from the account holder to provide an Form W-9, the QI must backup withhold on all reportable payments paid to the account holder and report those payments on Form 1099 or, in certain cases, provide another withholding agent with all of the informa-tion required for that withholding agent to backup withhold and report the payments on Form 1099.

Accounts established on or after January 1, 2001: For any account established by a U.S. nonexempt recipient on or after Janu-ary 1, 2001, the QI must (1) request from the account holder the authority to disclose its name, address, TIN (if available) and reportable payments; (2) request from the

account holder, prior to opening the account, the authority to exclude from the account holder’s account any assets that generate, or could generate, reportable payments; or (3) request that the account holder disclose itself by mandating the QI to transfer an IRS Form W-9 completed by the account holder. If a QI is authorized to disclose the account holder’s name, address, TIN and reportable amounts, it must obtain a valid Form W-9 from the account holder, and, to the extent the QI does not have primary IRS Form 1099 and backup withholding responsibility, provide the Form W-9 to the appropriate withhold-ing agent promptly after obtaining the form. If an IRS Form W-9 is not obtained, the QI must provide the account holder’s name, address and TIN (if available) to the with-holding agents from whom the QI receives reportable amounts on behalf of the account holder, together with the withholding rate ap-plicable to the account holder. If a QI is not authorized to disclose an account holder’s name, address, TIN (if available) and report-able amounts, but is authorized to exclude from the account holder’s account any assets that generate, or could generate, reportable payments, the QI must follow procedures designed to ensure that it holder’s account.

The IRS generally does not audit a QI with respect to withholding and reporting obligations covered by a QI agreement if an approved external auditor conducts an audit of the QI. An external audit must be performed in the second and fifth full calendar years in which the QI agreement is in effect. In general, the IRS must receive the external auditor’s report by June 30 of the year following the year being audited. In general, the QI must permit the external auditor to have access to all relevant records of the QI, including information regarding specific account holders. In addition, the QI must permit the IRS to communicate directly with the external auditor, review the audit procedures followed by the external auditor, and examine the external auditor’s work papers and reports. In addition to the external audit requirements set forth in the QI agreement, the IRS has issued further guidance (the “QI audit guidance”) for an external auditor engaged by a QI to verify the QI’s compliance with the QI agreement. Rev. Proc. 2002-55, 2002-2 CB 435. An

external auditor must conduct its audit in accordance with the procedures described in the QI agreement. However, the QI audit guidance is intended to assist the external auditor in understanding and applying those procedures. The QI audit guidance does not amend, modify or interpret the QI agree-ment. A QI agreement expires on December 31 of the fifth full calendar year after the year in which the QI agreement first takes effect, although it may be renewed. Either the IRS or the QI may terminate the QI agreement prior to its expiration by delivering a notice of termination to the other party. However, the IRS generally does not terminate a QI agree-ment unless there is a significant change in circumstances or an event of default occurs, and the IRS determines that the change in circumstance or event of default warrants termination. In the event that an event of default occurs, a QI is given an opportunity to cure it within a specified time.

288 NYSBA Tax Section Comments, at 9.289 Staff of the Joint Committee Explanation of

President’s Budget Proposal, at 170–72. 290 See footnote 494 of the Staff of the Joint

Committee Explanation of President’s Bud-get Proposal, at 171, which provides: “For example, a U.S. issuer of a debt instrument with original issue discount is required to report the amount of the OID to the IRS on Form 8281 for inclusion in Publication 1212. This information can then be used by U.S. financial institutions to prepare Forms 1099-OID with respect to OID inclusions on the debt instruments issued by foreign issuers. In addition, U.S. securities laws require that an issuer of securities in the U.S. public markets provide general disclosure in the offering document with regard to the U.S. income tax consequences of ownership of the secu-rity; offering documentation for securities sold in foreign markets would not normally include that disclosure. It is important to note, however, that U.S. financial institutions are currently complying with full Form 1099 reporting on foreign securities held by U.S. persons. Compliance expertise is available in the market and could be retained by for-eign financial institutions to administer U.S. obligations.”

291 Louise Armistead, British Banks Revolt against Obama Tax Plan, Telegraph.co.uk, May 24, 2009.

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Foreign Account Tax Comliance

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