FACTA and the New Frontier in Offshore Reporting Enforcement

FATCA was passed to prevent U.S. citizens from evading tax by focusing primarily on foreign financial institutions with U.S. account holders.

The Foreign Account Tax Compliance Act (FATCA) was enacted as part of the 2010 Hiring Incentives to Restore Employment Act, and its provisions became effective as of 7/1/14. FATCA was passed to prevent individuals from evading U.S. income tax through the use of offshore accounts; its scope, therefore, is understandably wide¬ranging. Efforts aimed at spurring compliance by individuals have been a U.S. priority for some time; the requirement to file the Report of Foreign Bank and Financial Accounts (FBAR) has received particular emphasis in recent years. Rather than further targeting individuals, FATCA primarily focuses on the foreign financial institutions where accounts are held. However, FATCA’s ultimate goal is the same as those of prior efforts in the offshore realm—to gain as much information as possible about offshore accounts with U.S. connections, and to ensure that all U.S. reporting requirements for those accounts are met. FATCA is best understood within this wider picture of U.S. efforts regarding offshore accounts.

While the FBAR requirement has existed for decades, focus on offshore accounts intensified in 2009, when the Department of Justice announced a deferred prosecution agreement with Switzerland¬based UBS. After the announcement of this agreement, the IRS introduced offshore disclosure programs for taxpayers who had previously failed to divulge offshore accounts (e.g., for failures to file FBARs or failures to include offshore income on their Form 1040). Since 2009, more than 45,000 taxpayers have made disclosures, paying penalties, back taxes, and interest of more than $6.5 billion.

Taxpayer Reporting

Two primary offshore disclosure programs exist: (1) the Offshore Voluntary Disclosure Initiative (OVDI), and (2) the Offshore Disclosure Procedures (the streamlined program). The OVDI program is the traditional route available for taxpayers to retroactively comply with offshore reporting requirements. Under OVDI, taxpayers submit eight years’ worth of FBARs and amended tax returns, and pay any tax shown as being owed, plus interest and a 20% accuracy¬related penalty. They also agree to pay a one-time penalty of 27.5% of the highest yearly aggregated balance of foreign assets subject to the OVDI program (importantly, this definition includes the fair market value of income¬producing foreign real estate, which is not required to be disclosed on the FBAR) over the eight¬year disclosure period.

As the name suggests, the streamlined program offers a simplified (and less costly) method for compliance: taxpayers submit six years’ worth of FBARs, three years’ worth of amended tax returns, and pay a one¬time penalty of 5% of the highest yearly aggregated balance of foreign assets. Importantly, the 5% streamlined penalty does not include the value of foreign income¬ producing real estate. Of note, however, is that taxpayers can participate in the streamlined program only if their failures to file foreign informational returns, report foreign¬sourced income on their tax returns, and pay tax on the income were due to “non¬willful conduct.” For streamlined program purposes, the term “non¬willful conduct” includes inadvertence, negligence, or mistake, or conduct that is the result of a good faith misunderstanding of the requirements of the law. When a taxpayer attempts to enter the streamlined program and fails to meet the non¬willful requirements, the taxpayer’s submission is rejected, and an audit results (taxpayers rejected from the streamlined program cannot thereafter seek admission to OVDI).

The FBAR must be filed by June 30 of the following year; individuals with interests in foreign financial accounts are required to file the form to disclose such interests if the aggregated value of accounts subject to reporting exceeds $10,000 for the year. The FBAR is subject to a six¬ year limitations period. Penalties for failure to file can be significant: a penalty of the greater of $100,000 or 50% of the aggregated account balances can be imposed for each year when the failure to file is deemed willful (though recent Service issuances make clear that the overall penalty amount will be capped at 100% of the account balances in the highest open year). Though rare, criminal charges can also be pursued against individuals who willfully fail to file. For non¬willful failures, penalties of $10,000 per account per year can be imposed (though, in most cases, the non¬willful penalty will not exceed $10,000 per year).

Although FATCA focuses on different targets than the FBAR, their ultimate aims are similar— both are intended to supply the U.S. with information on U.S. citizens with accounts overseas. The primary difference between the two is the targets from whom information is sought—the FBAR seeks information from the individuals that hold interests in the accounts, while FATCA seeks information from the institutions where the accounts are held. However, FATCA also applies to individuals and Form 8938, Statement of Specified Foreign Financial Assets, is required for individuals who meet the various thresholds. This is in addition to the FBAR filing.

Foreign financial situation reporting

The statutory components of FATCA are contained in Sections 1471 through 1474. FATCA’s primary function with respect to foreign financial institutions is to create a withholding and reporting system for relevant information related to account holders with U.S. connections. Section 1471(a) requires withholding agents to withhold a tax equal to 30% of any withholdable payment made to a foreign financial institution that does not meet FATCA’s requirements. Withholdable payments are defined in Section 1473(1) and encompass:

(A)(i) any payment of interest (including original issue discount), dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income, if such payment is from sources within the United States, and

(A)(ii) any gross proceeds from the sale or other disposition of any property of a type which can produce interest or dividends from sources within the United States.

A foreign financial institution is defined under Section 1471(d)(5) as an entity that accepts deposits in the ordinary course of a banking or similar business, holds financial assets for the account of others as a substantial portion of its business, or is engaged primarily in the business of investing, reinvesting, or trading in securities, partnership interests, commodities, or any interest in such securities, partnership interests, or commodities (or holds itself out as being engaged in such activities). Reg. 1.1471¬5(e) further expands the scope of this term to include investment entities, specified insurance companies, and holding companies. Specifically excluded from the definition of a financial institution under the regulations are certain excepted nonfinancial entities, excepted inter¬affiliate foreign financial institutions, Section 501(c) entities, and nonprofit organizations.

Foreign financial institutions can avoid the Section 1471(a) withholding requirements through compliance with Section 1471(b). Section 1471(b) allows foreign financial institutions to enter into agreements (FFI agreements) with the U.S. government to provide certain information to the U.S. on a continuing basis; they can also meet standards set forth in Section 1471(b) to avoid the requirements. FFI agreement requirements are delineated in Reg. 1.1471¬4. Under these regulations, a foreign financial institution is required to deduct and withhold tax with respect to payments made to recalcitrant account holders and nonparticipating foreign financial institutions to the extent required under Reg. 1.1471¬4(b) (this regulation is largely reserved for further regulations). Under Section 1471(d)(6), recalcitrant account holders are account holders who fail to comply with reasonable requests for information needed to determine whether an account has U.S. connections, or fails to provide a waiver when foreign law would prevent the reporting of relevant information.

Institutions are also required to obtain information from account holders to determine whether an account has connections to a U.S. party, recalcitrant account holder, or nonparticipating foreign financial institution. In addition, institutions must adopt a compliance program regarding the FFI agreement and cure any default events under the FFI agreement on their occurrence. Foreign financial institutions that have entered into FFI agreements are permitted to file a collective refund on behalf of certain account holders and payees for amounts withheld that were in excess of the account holder or payee’s U.S. tax liability.

Intergovernmental agreements

Under FATCA’s requirements, conflicts could have existed between a foreign financial institution’s requirements under a FFI agreement and the pre¬existing laws of the country in which it was domiciled. Based on this potential conflict, many foreign governments have entered into intergovernmental agreements (IGAs) with the U.S. in connection with FATCA’s enforcement. The IGAs essentially provide an alternate method for parties to comply with the FATCA requirements. In many of the IGAs, reciprocity exists between the participants— information is both provided to the U.S. by the participant country and provided by the U.S. to the participant (regarding taxpayers with connection to that country who maintain financial interests in the U.S.). IGAs do not provide an exception to the FATCA requirements, but rather make available streamlined processes for compliance with its terms.

Two IGA models exist: the “Model 1 IGA” and the “Model 2 IGA.” As of June 2015, the U.S. lists 98 countries classified as having entered into Model 1 IGAs, and 14 countries that have entered into Model 2 IGAs. Several of the countries listed have not executed finalized agreements, but have reached agreements in substance, and therefore, consented to being listed as having a FATCA agreement in place.

The Model 1 IGA was developed by the U.S. in conjunction with France, Germany, Italy, Spain, and the U.K. Under the Model 1 IGA, foreign financial institutions report information required under FACTA to their home country’s government, with that government then providing the information to the U.S. Foreign financial institutions in Model 1 IGA countries need not sign a FFI agreement, but are still required to register on the FACTA registration website.

Under the Model 2 IGA, foreign financial institutions report information directly to the U.S., and are required to enter into a FFI agreement. The country that signs the Model 2 IGA directs foreign financial institutions located within its borders to register with the U.S. and provide all required information to it directly. Some information related to recalcitrant account holders will be shared directly between the government entering the Model 2 IGA and the U.S.

Withholding

Payments made from the U.S. to foreign entities other than financial institutions are covered under Section 1472. Like under Section 1471, the withholding agent is required to deduct and withhold a tax equal to 30% of such payment, unless the Section 1472(b) requirements are met in regards to the beneficial owner of the payment. Section 1472(b) requires a beneficial owner to provide the withholding agent with either: (a) the relevant information of each substantial U.S. owner of such beneficial owner (with the withholding agent then required to provide such information to the U.S. in a manner proscribed by the Secretary); or (b) a certification that the beneficial owner has no U.S. owners. The term “substantial United States owner” is defined in Section 1473(2) as:

(A)(i) with respect to any corporation, any specified United States person which owns, directly or indirectly, more than 10 percent of the stock of such corporation (by vote or value),

(A)(ii) with respect to any partnership, any specified United States person which owns, directly or indirectly, more than 10 percent of the profits interests or capital interests in such partnership, and

(A)(iii) in the case of a trust—

(I) any specified United States person treated as an owner of any portion of such trust under subpart E of part I of subchapter J of chapter 1, and

(II) to the extent provided by the Secretary in regulations or other guidance, any specified United States person which holds, directly or indirectly, more than 10 percent of the beneficial interests of such trust.

The term also includes any party treated as the owner of any portion of a trust.

Transition period

Given the scope of FATCA requirements, many practitioners raised concerns regarding implementation of all of the requirements by 7/1/14. As a result, the Service released Notice 2014¬33, 2014¬21 IRB 1033, which created a “transition period” for FATCA’s implementation by foreign financial institutions and withholding agents with respect to the due diligence, reporting, and withholding provisions. During the transition period, the Service will take into account whether a withholding agent has made reasonable efforts to modify its account opening practices and procedures to document the status of payees. The Notice requires parties to make a good¬faith effort to comply with FATCA’s provisions during the transition period; when no good¬faith effort is made, relief will not be available.

Penalties for individual failures

Penalty assessment in this context can be expected to be aggressive; the Service likely will point to the availability of the offshore disclosure programs (and publicity given thereto) as factors affecting whether a taxpayer’s failure to file the form was willful (fairly or not). When willful penalties are assessed, the Service will typically impose a penalty of the greater of 50% of the aggregated account balances or $100,000. In extreme cases (which are more likely to be discovered among taxpayers whose accounts are first disclosed through FATCA’s application), the Service has made clear that it can (and, in some cases, will) assess penalties up to 100% of the aggregated balance of offshore accounts in the highest year in which the limitations period remains open. Importantly, if applied, this penalty will exceed the amount of the current account balances in many, if not most, cases.

During the transition period, taxpayers with previously undisclosed foreign accounts may be faced with their “last chance” for voluntary compliance and the lowered penalty offered by the same. Making clear to taxpayers that time may be running short to come forward—and the potential ramifications of failing to do so—is therefore of tremendous benefit to them.

Effects

Based on an analysis of its requirements, FATCA’s scope and effect are clearly far¬reaching. For foreign financial institutions, new reporting requirements exist for both holders of accounts and payments made to them. Many foreign financial institutions have taken steps to prevent individuals with U.S. ties from either opening or maintaining accounts, given the potentially onerous reporting requirements associated with them. Countries involved with FATCA (the U.S. and countries that have entered into IGAs) will also need significant investment to begin implementing its requirements.

However, the biggest effect of FATCA will likely be on individuals with offshore accounts, both in enforcement of FBAR requirements and assessment of penalties for the failure to meet them. As stated (and has been well¬publicized), offshore compliance has been a primary area of focus for the IRS for several years; to date, the Service’s preferred method has been incentivizing retroactive compliance through the offshore disclosure programs. These efforts have been enormously successful—as indicated, more than $6.5 billion has been paid to the government as a result of these programs, with more than 45,000 taxpayers coming forward.

FATCA gives the Service a means of finding taxpayers who do not seek out methods of compliance for past omissions. Offshore disclosure programs have been available since 2009; thus, at some point, the Service will get diminishing returns from asking taxpayers to voluntarily come forward. As most major jurisdictions have entered into agreements under FATCA (including the majority of traditional “tax haven” jurisdictions), taxpayers who have failed to meet prior FBAR filing requirements can expect those failures to come to the Service’s attention.

Conclusion

FATCA has been an important development in the Service’s attempt to ensure that all U.S. reporting requirements are met for offshore accounts with U.S. account holders. It is important to note that there are various other filing requirements with other governmental agencies, such as the Department of Commerce’s Bureau of Economic Analysis (BEA) Forms BE¬10 and BE¬13. This article does not cover all filing requirements for foreign owners of U. businesses or U.S. citizens with foreign investments.