FATCA: myths, mysteries, and practical perspectives.

• Author: Sontag, Kimberly Tan Majure Matthew R.

The Foreign Account Tax Compliance Act (FATCA) was enacted in response to a series of U.S. tax evasion scandals that came to light in 2006. (1) Comprising sections 1471 through 1474 of the Internal Revenue Code, (2) FATCA is a withholding regime that closely resembles section 1441, et seq. (the chapter 3 withholding rules). At a very high level, both chapter 3 withholding rules and FATCA are triggered by a cross-border payment--specifically, an outbound payment made to a foreign payee. Before the payment is made, the payor is required to identify the foreign payee and understand enough about the payee to determine whether and the extent to which withholding applies, and withhold as necessary.

As with any new and complicated regime, FATCA has generated much discussion and debate, mostly among U.S. tax advisers and financial institutions, and to a lesser extent among non-financial companies. In the financial institution context, much of the debate balances theoretical approval of FATCA's anti-evasion policies with real apprehension about the potential cost of FATCA compliance. The non-financial discussion is more muted, reflecting confusion regarding FATCA's application to non-financial companies. Ironically, the press coverage surrounding FATCA has been so focused on issues facing the financial institutions that public debate may have clouded, and not clarified, the issues facing non-financial companies.

The U.S. Treasury Department and Internal Revenue Service issued lengthy proposed FATCA regulations in February 2012. Given their complexity, it is unlikely that the debate and confusion will end with the promulgation of final regulations. (3) This article discusses several of the "myths and mysteries" that seem to have arisen concerning FATCA and makes suggestions for reconciling the legal considerations non-financial companies face in the FATCA area.

Myth No. 1: FATCA Is a Tax

First and foremost, FATCA is not a tax. The FATCA rules are very similar in structure to the chapter 3 withholding rules, but FATCA does not focus on income, tax rates, or tax liability. At its core, FATCA seeks to identify U.S. investors with foreign financial interests, making it easier for the IRS to audit income and assets that could otherwise remain hidden offshore. FATCA accomplishes this objective by compelling the aid of "withholding agents," defined under FATCA as any U.S. or foreign persons having control, receipt, custody, disposal, or payment of a cross-border item. (4) Once a withholding agent has an obligation to make a qualifying cross-border payment, the agent must obtain information from the foreign payee, regarding significant financial involvement the payee has with U.S. taxpayers. As a general matter, the foreign payee must identify its substantial U.S. owners or certify that it qualifies for an exception from information reporting requirements in documentation provided to the withholding agent prior to payment. A payee's failure to provide valid documentation triggers a 30-percent enforcement levy on the payment, which is collected and remitted to the IRS by the withholding agent. A withholding agent's failure to obtain valid documentation or, alternatively, to collect the 30-percent FATCA charge, results in secondary liability for the withholding agent. (5) The withholding agent is also responsible for providing foreign payee information to the IRS regarding FATCA payments made and the substantial U.S. owners identified in the prior year. (6)

Most important, if FATCA operates as it is intended, the U.S. government will receive information valuable for identifying potential U.S. tax evaders, and the 30-percent FATCA charge simply will not apply. (7)

In contrast, the chapter 3 withholding rules implement an enforcement mechanism for a "real" tax. Generally, a foreign person earning U.S. source income that is not effectively connected with a U.S. trade or business is not subject to net basis federal income tax. The income--referred to as "fixed or determinable annual or periodical," or "FDAP"--is instead subject to a gross basis tax. (8) The obligation to remit the tax to the IRS is not placed on the foreign payee, but instead on the payor of the income, i.e., the withholding agent.9 By statute, the tax is generally imposed at a 30-percent rate, but may be reduced or eliminated entirely under the auspices of an applicable tax treaty between the United States and the foreign person's residence country. (10) The foreign payee must certify ownership of the income, foreign residence, and eligibility for treaty benefits on pre-payment documentation provided to the withholding agent. The withholding agent is tasked with validating any documentation provided, withholding and remitting the appropriate amount of tax to the IRS, and filing annual information returns reporting the payments. (11) In the absence of valid withholding documentation (currently, the Form W-8BEN), the withholding agent must withhold tax at the default, 30-percent rate. The withholding agent is secondarily liable for any underwithheld tax. (12)

At a high level, FATCA and chapter 3 withholding look very much alike. It is important, however, to remember how different they are in nature, and to understand how those differences have influenced the specific rules under each regime.

First, whereas chapter 3 withholding applies to U.S. source FDAP "income," FATCA applies to payments viewed as posing a relatively high risk of U.S. tax evasion. Thus, FATCA defines "with-holdable payments" more broadly, to include not only U.S. source FDAP income but also gross proceeds from the sale of U.S. interestand dividend-paying instruments (which, considering the seller's basis, is at least partially a non-income item). (13) At the same time, FATCA does not apply to certain non-financial payments made in the ordinary course of the withholding agent's business (OCB payments), which, while falling within the scope of U.S. income taxing jurisdiction, are viewed as posing a relatively low risk of U.S. tax evasion. (14) (Financial payments generally remain subject to FATCA...