One might think the “foreign” in Foreign Account Tax Compliance Act (FATCA) relates only to a handful of companies. But proposed FATCA regulations have such a broad extraterritorial reach for U.S. financial institutions that they’re taking on renewed importance at all levels of a firm.  

At an Internal Revenue Service’s meeting last week to air objections to FATCA, banks, insurers and trade groups weighed in on some potential challenges to their firms. While the discussions fell short on actual solutions, the meeting highlighted how much work still needs to be done by regulators on the rule-drafting side and CFOs working for U.S. banks and insurers on the compliance side.  

FATCA, which was enacted in 2010, applies to any U.S. bank making dividend payments or interest payments to a non-U.S. entity. Under the proposed rule, the U.S. bank making the payments would be required to withhold the interest or other payments made to a foreign financial institution (FFI) that fails to report certain account information to the IRS. And if the U.S. bank fails to withhold as required, it would be liable for the withholding tax plus potential penalties and interest.

The proposed regulations require separate U.S. account identification for different types of entities as well as strict information reporting and withholding requirements for FFIs, other foreign entities, and U.S. withholding agents.

“There’s been an emergence of recognition that FATCA is truly not just a tax issue. We are seeing increased focus, participation and awareness of compliance, operations, business, technology, general counsel’s office and CFOs” of financial institutions, says Steve Beattie, Anti-Money Laundering Services and FATCA Leader for Financial Services at Ernst & Young.

“Across the board, all U.S.-based financial firms are recognizing they have a significant distance to go” in terms of preparedness, he adds. The IRS has said that registration by FFIs via an online database system will be made available by January 1, 2013, the first effective date for U.S. documentation compliance with FATCA.

Before the proposed FATCA rules, there was no information reporting requirement imposed on U.S. institutions that have accounts with foreign people, according to Adrienne Baker, partner in the Financial Services and Investment Management and Tax department at Dechert, an international law firm. Now, however, there’s “an incentive for the withholding agent to get it right. U.S. institutions will end up being withholding agents,” she says.

Indeed, U.S.-based payers of dividends or interest income would not only become withholding agents, they would be “essentially deputized enforcers for the IRS,” a recent Baker & Hostetler FATCA report notes.

That thinking isn’t too far off from the intent of Congress, it appears. The law was act enacted to police non-compliance by U.S. taxpayers using foreign accounts.

With the proposed rules, however, FATCA has begun to have a much broader scope. Life insurance companies, for one, are not exempt from the proposed tax rules, though the requirements involving pension annuities and similar product areas still need to be clarified under the tax law.

U.S. insurers, as it stands, will have to determine if an FFI, for example, is FATCA-compliant. If not, the insurer will have to withhold 30% on some payments. Under the drafted rules, FATCA also applies to U.S. stock brokers and asset managers involved in listed derivatives and stock-option trades.    

“The big eye opener is that it [FATCA] would also affect the gross proceeds from any disposition of a security that would give rise to U.S.-source interest and dividend income,” adds Dechert’s Baker.

Under the proposed rules, for example, if a person holds a debt obligation or share of stock from a U.S. issuer that’s paying interest or dividend income and sold the position, 30% of the gross proceeds would be subject to withholding and tax, according to Baker. The seller would be subject to withholding even if he or she lost money on the sale.

A Sticking Point
Just identifying accounts within business units that must comply with FATCA has become a sticking point for many financial services companies. In a recent KPMG survey, account-identification requirements were cited by 31% of 150 U.S. bank respondents and 30% of the 100 foreign bank respondents as the biggest compliance challenge for their institution under FATCA.

“It is going to be very difficult to classify,” said Laurie Hatten-Boyd, a Washington National Tax principal at KPMG.  The draft rules currently state that it’s up to the withholding agent to make the difficult determination whether or not someone is in compliance. That’s going to be a big challenge, she said.

A big issue for U.S. firms is having the systems in place to handle all of the compliance steps needed, she adds. “It’s very important that they have their teams in place. Right now they need to have steering committees put together with IT, operations, and their tax departments all together on one team addressing this.”

Some financial industry CFOs, she notes, are very aware of the importance of FATCA to their operations and “are keeping their finger on the pulse from their steering committees and having regulator meetings.” But other finance chiefs are still educating themselves, she says. 

At least one other approach to FATCA implementation has already surfaced, however. The concept, the Intergovernmental Approach, came to fruition last February when the Treasury initiated draft guidelines on FATCA regulations.

Under this plan, FFIs would report to their own home jurisdiction, which would then report the information to the U.S. government as part of an exchange of information arrangement with treaty jurisdictions.

The U.S. government is already in discussions with a handful of countries on the idea. “This alternative arrangement has a lot of interest in seeing just how many countries will sign on,” says Dechert’s Baker. It is important, she notes, to see how these agreements can be in place before FATCA withholding or before a financial institution would have to start the process of entering into an agreement with the IRS.

Though the alternative approach was considered a positive development, Baker notes it also raised other pressing issues. “To avoid the withholding, not only do they (FFIs) have to report on accounts, but also for account holders where they can’t get the information, there’s a requirement that will kick in at some point, where they have to withhold on those [foreign investors]. This was the cause of a lot of concern,” she says.  

The IRS is expected to be out with final regulations by September. But discussions have already surfaced about extending the initial deadlines.