FATCA myths and mysteries.

• Author: Majure, Kimberly Tan
• Position: Part 2 - Foreign Account Tax Compliance Act

At long last, the IRS has released final regulations under the Foreign Account Tax Compliance Act (the "final FATCA regulations'). (1) Measuring a robust 545 pages, the new regulations certainly provide more detail on the application of sections 1471 through 1474 (2) to payments to foreign financial and non-financial payees. If only the regulations provided an equal measure of clarity. Months after their publication tax advisors and industry professionals are still struggling to decipher the new rules and to balance FATCA's underlying objectives with their own resource constraints.

This article is a follow-up to "FATCA: Myths, Mysteries, and Practical Perspectives," ("Myths Part 1"), which was published in July-August, 2012, edition of The Tax Executive. Myths Part 1 addressed substantive and practical issues raised in the proposed FATCA regulations (3). For the most part, the general theme we explored in Myths Part 1 carries over into this article: Beware the gap between the conceptual and the practical application of the FATCA regulations.

The final FATCA regulations impose heavy compliance burdens. The heaviest burdens fall on financial institutions, but the implementation costs that non-financial companies face are nonetheless substantial. The final FATCA regulations contain several new twists on the rules for nonfinancial companies that were intended to reduce their costs of compliance and to increase the time they had to get their compliance processes in order. But do these changes really help? To find out, you should invest time now to realistically assess the final FATCA regulations, to determine how your company will implement them, and to project implementation time and costs. This investment should pay dividends--thankfully, the non-reportable kind.

FATCA Is Not a Tax

We've said it before and we'll say it again--FATCA is not a tax; it's not even about income (at least not directly). FATCA is about information.

Provisions of the Code which gather information are as common as those which gather revenue. As an example, consider section 6038B, which requires certain U.S. persons to file a Form 926 every time a transfer of property is made to a foreign corporation. Typically, neither the transferor nor the transferee recognizes any income. But, regardless, the transfer of the property triggers a reporting obligation. The fact that the transfer is not a recognition event is irrelevant. The transfer needs to be reported, along with certain facts about the transferor, the transferee, and the property transferred. Failure to report these facts results in a penalty.

Conceptually, FATCA works the same way. Someone makes a qualifying payment, and the payment triggers a reporting requirement. Sometimes the payment is a taxable amount (e.g., interest); sometimes not (e.g., the basis component of gross proceeds). Sometimes the payment is U.S. source and sometimes it isn't (again, consider a foreign seller's gross proceeds). Like the section 6038B reporting obligation, whether the payment is taxable in the United States is irrelevant. Once a qualifying payment is made, the payment needs to be reported, along with facts about the transferee. These facts specifically include information about the transferee's substantial U.S. owners. (4) Failure to report these facts results in 30 percent withholding assessed on the gross amount of the payment. The Code styles the 30 percent charge as a "tax." But let's face it: This 30 percent charge is essentially a penalty, not a tax.

And the more FATCA guidance we get, the more evident this is.

To this point, consider the two primary exceptions from FATCA withholding: the exceptions for payments on grandfathered obligations and excluded nonfinancial payments. (5) The final FATCA regulations expanded the types of obligations which may be grandfathered to include an obligation (6) that gives rise to a withholdable payment that is a dividend equivalent payment under section 871(m) and any agreement that requires that collateral be pledged to secure a grandfathered obligation. The final FATCA regulations also replaced the ordinary course of business ("COCB") exception of the proposed regulations (7) with an exception for nonfinancial payments. (8) Ordinary course of business is now an irrelevant concept. Qualification for the exception depends solely on whether a payment appears on the "good" list of payments (excepted from FATCA withholding), the "bad" list (subject to FATCA withholding), or no list at all (also subject to FATCA withholding).

We'll talk in more detail about these exceptions, below. For now, let's focus on the fact that the two exceptions are of limited practical benefit despite their very broad reach (especially for payors that are nonfinancial companies). If FATCA were simply a tax, you would think that grandfathered or otherwise excepted payments would be excepted from FATCA altogether. You would think that you could pretty much ignore these payments. And that was, in fact, the approach that the proposed regulations took, at least with respect to payments covered by the OCB exception. (9)

The final regulations don't work this way. While FATCA withholding is not required on payments that qualify as grandfathered or nonfinancial payments, both of these payments remain subject to information reporting. (10) If you don't believe it, take a look at the draft Form 1042-S covering 2014 payments (released April 2, 2013). (11) Among other things, the form requires the withholding agent to indicate a chapter 4 withholding exemption applied, e.g., for grandfathered payments (code 13), where the payee is not subject to chapter 4 withholding (code 15), and for excluded nonfinancial payments (code 16). The draft Form 1042-S also requires the filer to note the chapter 4 status of the payee (e.g., as active NFFE, passive NFFE with no substantial U.S. owners, or passive NFFE with substantial U.S. owners). The draft Form 1042 (12) (released a few days later) requires a reconciliation of all of a withholding agent's U.S. source FDAP payments, including a specific breakout (by reason for exemption) of income not subject to FATCA withholding. Any variance between total payments reported on the withholding agent's Forms 1042-S and payments reported on the Form 1042 must be explained in detail.

What does this prove? The real...