Background

FATCA is a new tax regime being introduced by the US government, requiring global participation. The goal is to prevent tax evasion by US taxpayers or foreign entities in which US taxpayers hold substantial ownership.  The act will require Foreign Financial Institutions (FFIs) to report to the US government and withhold 30 per cent tax on US sourced income and gross proceeds of sale in cases of non-compliance.

This regulation is expected to be finalised by the end of summer 2012 and fully implemented by the end of 2017.

The main requirements for FATCA implementation are customer identification – for both new and existing customers - witholding tax and reporting.

Participant Classification

FATCA will place onerous operational requirements on a wide range of FFIs, including hedge funds, asset managers, wealth managers and custodians. They will have to identify relevant accounts and report these to the US Internal Revenue Service.

Under FATCA, FFIs are classified into six main categories:

1. Participating Foreign Financial Institution – FFIs who agree to enter into an agreement with the US Internal Revenue Service to supply the required information to identify US Accounts;

2. Deemed Compliant Foreign Financial Institution – entities that don’t need to execute a FATCA agreement to comply with FATCA;  

3. Exempt Beneficial Owner – Retirement funds may be exempt or deemed compliant depending on their structure and whether the country has a tax treaty with the US;

4. Non-Participating Foreign Financial Institutions – all foreign financial institutions that have not entered into agreement with the US IRS;

5. Recalcitrant Individual Account Holders – uncooperative account holders who refuse to provide the necessary information to become FATCA compliant;

6. Non-Financial Foreign Entities - a foreign entity that is not a financial institution.

FATCA - the reality

In reality, the desired result of FATCA is to generate reporting to the IRS and reduce the chances of tax evasion. Firms will face key challenges in detecting and reporting on US customers in existing and new accounts. There is also a likelihood of smaller companies disinvesting from the US.

Recent announcements have reduced the required due diligence for pre-existing accounts to analysis of electronic records. Know Your Customer and anti-money laundering documentation remains the key challenge for new clients. Systems and processes will need to be in place to detect US clients, using indicia defined by the IRS, to provide the information required and to deduct 30 per cent withheld tax in the role of Withholding Agent where applicable. FFIs will need to make a strategic decision to either establish a business model that is compliant with FATCA or exit the market for US clients. Smaller FFIs may decide to disinvest from the US.

Already there is evidence that American wealth management clients who want to bank offshore are being redirected to private banking in the US.

Recent concessions have reduced the reporting burden from an asset manager’s perspective, with lighter reporting requirements and a five year time period before withholding is required. Fund scheme documentation (prospectus and offering memorandums) will need to be amended and gain regulatory approval to accommodate FATCA. Regulatory bodies will need resources available to approve these documents.

US paving the way

There is a global desire to reduce tax evasion. The governments of the US, France, Germany, Italy, Spain and the UK have all agreed to become FATCA Partners, to create a common approach to FATCA implementation. The concern is whether the FATCA partners reach agreement in accordance with the implementation timetable. There is ongoing debate as to how the FATCA partners will impact the introduction of the legislation. They could introduce an additional up front administrative burden to FFIs, as the work done to become FATCA compliant may have to be replicated for each FATCA Partner.

It is expected that other countries will introduce the same requirements as FATCA. The US has already indicated that it will reciprocate data sharing, by collecting and exchanging information on accounts held in US Financial Institutions by residents of the FATCA partners.

Benefit or costly burden?

Currently, FATCA will only benefit the IRS, to the detriment of the investor, and will be a costly burden on the financial services industry. Additionally, high administration costs are likely to end up being passed onto investors.  

Two of the most challenging implications of FATCA for asset managers will be coping with changing requirements for client on boarding and classifications. As a consequence, these will potentially generate the higher implementation costs. Although these costs will vary, they could be significant.

The recommendation for FFIs is to not just build a FATCA solution but rather build a global solution, but as more countries follow the lead of the US, a genuine concern is that if more countries join, will this become even harder to regulate and enforce?

Each FFI is required to nominate a Responsible Officer. This is fundamental to the successful implementation of FATCA. It creates specific ownership and responsibility to a regulation that is seen as providing no benefit to financial institutions. A formal project structure already needs to be in place, with a detailed project plan, owners and timelines.

FATCA becomes effective from June 2013 with a phased implementation through to 2017 and it’s not going away. Sitting back and waiting for further clarification of requirements is not an option - FATCA cannot be ignored.