This is the second of a two-part series. Part I appeared in the January issue of The Metropolitan Corporate Counsel. In it, the authors discussed two sets of the key provisions of the Foreign Account Tax Compliance Act of 2009 incorporated into the Tax Extenders Act of 2009 (the "Act"): 1) substantive tax law changes, and 2) increased individual reporting. Part II continues below with the third set of key provisions. Please visit our website at www.metrocorpcounsel.com for Part I.
3. Increased Third-Party Compliance And Reporting
The most significant changes proposed by the Act relate to obligations imposed on foreign third parties. Third parties caught by these new rules include foreign banks and other "financial institutions" using the Act's liberal definition of the term so that most types of investment funds, including hedge funds and private equity funds, are subject to these rules.
New Withholding Tax
The cornerstone of the new third-party information reporting initiative is the imposition of a 30 percent withholding tax on "withholdable payments" made to a foreign entity. A withholdable payment includes all U.S. source fixed, determinable, annual or periodical income ("FDAP") and any gross proceeds from the sale of property that can produce U.S. source interest or dividends. The definition greatly broadens the tax that may be imposed on foreign persons. Interest that would otherwise qualify for the "portfolio interest" withholding exemption is subject to withholding under this provision. Similarly, the gross proceeds, not just the net gain, realized from the sale of property giving rise to dividend or interest income will be subject to this withholding tax. These are significant changes from current U.S. federal tax law where portfolio interest and capital gains realized by a foreign person are generally exempt from U.S. federal withholding taxes.
Current withholding tax provisions would be amended to prevent a duplication of U.S withholding taxes in case of an overlap with the new withholdable payments tax. In certain cases, a beneficial owner may be entitled to a refund or credit for any taxes withheld under this new provision.
Application to Financial Institutions
The withholding tax applies to any withholdable payment made to a foreign financial institution unless the institution enters into an agreement with the Treasury described below ("Treasury Agreement"). The Treasury Agreement will generally require the financial institution to: 1) obtain information regarding each account holder in order to determine whether the account holder is a United States person meeting certain requirements or has United States persons as substantial owners ("United States accounts"); 2) comply with due diligence and verification procedures mandated by the Treasury; 3) report the identities, account balances and account transaction activity for certain United States accounts; and 4) deduct and withhold 30 percent from any "passthru payment" made to certain persons. Passthru payments are those made by the foreign financial institution to: 1) an account holder who fails to provide certain identifying information, 2) an account holder who fails to waive any provision of foreign law that would prevent reporting of the holder's information to the U.S. government; 3) a payment made to another foreign financial institution that has not entered into a Treasury Agreement; or 4) a payment made to another foreign financial institution that elects to have the payments be subject to the 30 percent withholding tax. Some of the reporting obligations can be replaced with I.R.S. Form 1099 reporting if the Treasury allows the foreign financial institution to do so. In either case, the financial institution must agree to comply with any request by the Treasury for additional information relating to the withholdable payments. The requirements imposed by the new Treasury Agreement are in addition to any requirements imposed under the Qualified Intermediary program.
The withholding provisions of the Act use the same expansive definition of a "foreign financial institution" as that used for the increased individual reporting obligations discussed above. An entity is treated as foreign for this purpose if it is not formed under the laws of the United States, even if the fund's investment managers are located within the United States. Thus, private equity funds, hedge funds and most other offshore investment vehicles formed outside of the United States should be foreign financial institutions for this purpose.
The Act defines the term "United States account" as any "financial account" which is held by one or more "specified United States persons" or "United States owned foreign entities." The Act defines the term "financial account" as any depositary or custodial account or, unless otherwise excluded by the Treasury, any equity or debt interest in the financial institution itself. Equity or debt interests in the financial institution itself are treated as a financial account maintained by the financial institution for this purpose, but are not treated as a financial account if such interests are regularly traded on an established securities market. Thus, an equity holder in, or lender to, a private equity fund should be an account holder with a foreign financial institution for this purpose.
A "specified United States person" is any United States person other than certain types of entities, such as corporations with regularly traded equity, tax-exempt organizations, banks, mutual funds and real estate investment trusts. The Act also defines the term "United States owned foreign entity" as any foreign entity that has one or more "substantial United States owners." A foreign entity has a substantial United States owner if any specified United States person owns, directly or indirectly, more than 10 percent of the entity's equity. In the case of foreign corporations, the threshold is measured by vote or value, and in the case of foreign partnerships, the threshold is measured by profits or capital interests. No minimum ownership threshold by specified United States persons applies if the entity is a "foreign investment entity." Most investment funds, including hedge funds and private equity funds, should be treated as a "foreign investment entity" for this purpose. Therefore, a foreign investment fund has a substantial United States owner if it has any specified United States persons as direct or indirect owners. It is unclear how indirect ownership will be measured.
The Treasury Agreement can potentially conflict with local law. For example, if foreign law would prevent any information from being provided to the Treasury pursuant to the Treasury Agreement, the financial institution is obligated to either obtain a valid waiver of such law from each account holder or, if this is not possible, to close the affected account. This may not be possible because some countries do not allow customers to waive privacy laws. The definition of an account is very broad and includes items such as non-publicly traded debt or equity. Because this expansive definition would catch non-publicly traded debt or equity, an issuer may be contractually unable to close such an account ( i.e ., redeem the debt or equity).
The new withholding tax does not apply to withholdable payments made to a foreign financial institution if the beneficial owner of such payment is an excluded person. Excluded persons include foreign governments, political subdivisions or instrumentalities of a foreign government, certain international organizations, and foreign central banks. In addition, the Treasury has authority to exclude other classes of persons or certain financial institutions from withholding if the Treasury determines that such class poses a low risk of tax evasion. A foreign financial institution may be eligible for this exclusion if it does not have any United States accounts and meets certain other ongoing requirements.
The imposition of the new withholding tax is meant to force a large cross-section of the global financial system to comply with the Act's information reporting obligations. If a foreign financial institution does not enter into the Treasury Agreement, all withholdable payments made to that entity are subject to the 30 percent withholding tax. The tax is not limited to payments made or otherwise attributable to certain account holders at the financial institution such as specified United States persons. Thus, any foreign entity classified as a financial institution by the Act may need to enter into a Treasury Agreement in order to avoid the 30 percent withholding tax on any U.S. investments even if the entity currently has no United States account holders.
Other Foreign Entities
The new withholding tax also applies to any withholdable payment made to a foreign non-financial institution entity unless certain certification requirements are satisfied. If the beneficial owner is the recipient entity or a non-financial institution foreign entity, the beneficial owner must provide the withholding agent with either 1) certification that the entity does not have any direct or indirect substantial United States owners or 2) the name, address and tax identification number for each substantial United States owner. A withholding agent must report the above information with respect to specified United States persons to the Treasury.
The requirement to withhold does not apply if the beneficial owner is an excluded entity. Excluded entities include corporations with regularly traded equity, foreign governments and their instrumentalities, central banks and any other class of persons identified by the Treasury as excluded entities. Additionally, the Act grants the Treasury authority to exempt any class of payments identified as posing a low risk of tax evasion.
This provision generally would apply to payments made after December 31, 2012. Because of the significant issues involved in implementing this provision, this effective date may be very optimistic. When the original Qualified Intermediary rules were introduced, their effective date was pushed back several times due in part to the complexities of implementation. Tax practitioners are already pushing for Congress to allow the Treasury to extend the effective date by regulation so that both the government and taxpayers will have adequate time to properly implement this novel and complex regime.
L. Wayne Pressgrove Jr . and John Clay Taylor are U.S. tax lawyers with King & Spalding.Mr. Pressgrove is resident in the firm's Atlanta office and Mr. Taylor in the firm's London office.