Executive Summary

The Foreign Account Tax Compliance Act (FATCA), enacted in 2010 as part of the Hiring Incentives to Restore Employment (HIRE) Act, aims to combat tax evasion by U.S. persons holding investments in offshore accounts. FATCA will require foreign financial institutions (FFIs) to report directly to the U.S. Internal Revenue Service (IRS) certain information about financial accounts held by U.S. taxpayers, or by foreign entities in which U.S. taxpayers hold a substantial ownership interest. FATCA attempts to achieve tax compliance by creating a complex diligence, reporting and withholding regime that operates in parallel with the existing U.S. withholding regime and which will potentially subject the income of an FFI to a new 30% withholding tax. To be sure to avoid this tax an FFI will have to enter into a special agreement with the IRS by 30 June 2013 (FFI Agreement), or else be subject to an intergovernmental agreement on FATCA (see below).

The disclosure, withholding and account termination requirements of FATCA raise significant issues under local data protection rules and other regulatory regimes and contract laws. FFIs subject to privacy and data protection laws are faced with a dilemma: either suffer the 30% FATCA withholding tax on withholdable payments or avoid U.S. investments that generate withholdable payments. Implementation of FATCA requires detailed information on data protection, banking secrecy and human rights law issues in all jurisdictions in which an FFI operates. Once the dilemmas and risks are clear, the next step is defining ways to effectively mitigate risks. Allen & Overy can assist FFIs in providing detailed information in all relevant areas and jurisdictions and can advise FFIs on how to mitigate risks and tackle FATCA compliance issues.

Background

On 8 February 2012, the U.S. Treasury Department and the U.S. Internal Revenue Service issued proposed regulations concerning FATCA.

Client identification and report obligations

FATCA will require FFIs to report directly to the IRS certain information about financial accounts held by U.S. taxpayers, or by foreign entities in which U.S. taxpayers hold a substantial ownership interest. An FFI is a financial institution that is not a U.S. person for U.S. federal income tax purposes. In general, an FFI is: (1) an entity that accepts deposits in the ordinary course of a banking or similar business; (2) an entity that holds financial assets for the account of others as a substantial portion of its business; or (3) an entity engaged (or holding itself out as being engaged) primarily in investing, reinvesting or trading in securities, partnership interests, commodities, notional principal contracts, insurance or annuity contracts or any interest (including futures, forward contracts or options) in any of these types of assets.

To comply with these new reporting requirements in a manner which ensures that it will not be subject to the new withholding tax, an FFI will have to enter into an FFI Agreement with the IRS by 30 June 2013. Under this agreement a “participating” FFI will be obligated to:

1. undertake certain identification and due diligence procedures with respect to its account holders;
2. report annually to the IRS on its account holders who are U.S. persons or foreign entities with substantial U.S. ownership; and
3. withhold and pay over to the IRS 30% of any payments of U.S. source income, as well as gross proceeds from the sale of securities that generate U.S. source income, made to (a) non-participating FFIs, (b) individual account holders failing to provide sufficient information to determine whether or not they are a U.S. person, or (c) foreign entity account holders failing to provide sufficient information about the identity of its substantial U.S. owners. The FFI may also need to close the accounts described in (b) and (c). In addition, a participating FFI will need to withhold under FATCA from payments made to non-participating FFIs, even if those payments have no connection to the U.S.

Regulatory concerns

The disclosure, withholding and account termination requirements of FATCA raise significant issues under local data protection rules and other regulatory regimes and contract laws.

Data protection

Data protection legislation is applicable as an FFI is required to collect, process and transfer personal data to the IRS (hereinafter together referred to as processing). However in some jurisdictions an FFI would only be allowed to process personal data if the data subject has consented to the processing of personal data for such purpose or has obtained the written authorisation of the local data protection supervisor.

Banking secrecy

FATCA represents an extensive change to the U.S. withholding tax and information reporting requirements. In particular, it seeks to penetrate bank secrecy rules to address tax evasion. However, local banking secrecy rules and regulations may constitute legal barriers in relation to reporting the required information to the IRS. For instance, in China and Turkey banking secrecy rules prohibit the disclosure of data to the IRS.

Human rights legislation

Anti-discrimination or other human rights legislation could also prohibit a FFI from being able to comply with the legal requirements FATCA sets forth. In Australia breaches of Australian racial discrimination laws arising from the practical consequences of establishing an individual's U.S. status cannot be waived by clients. In Chile, the constitution guarantees equality before the law and forbids discrimination against any person on criteria other than their personal capacity and suitability and, since this is a fundamental constitutional right, it also cannot be waived.

Intergovernmental Agreements on FATCA

Many FFIs, finance industry organisations and representatives of various countries have noted the conflict between the requirements of FATCA and the prohibitions on information sharing contained in non-U.S. law. In recognition of this conflict, model intergovernmental agreements (IGAs) have been designed which seek to resolve the conflict of laws issue by requiring that an FFI in a country that has signed the "Model I IGA" (a FATCA Partner) reports U.S. account information to its own government, which will then provide this information annually to the U.S. government under tax treaties or tax information exchange agreements. In addition, FFIs in such jurisdictions will be free of FATCA withholding on income they receive or pay.

The Netherlands, France, Germany and Italy have – among others – already expressed their willingness to enter into negotiations for an IGA, and the UK, Denmark, Spain and Mexico have already signed them. However it will undoubtedly require quite some time to negotiate and implement the various bilateral agreements under FATCA with all interested countries. This also means that FFIs located in countries which have not entered into an IGA potentially face the unpleasant choice of violating local laws or incurring the FATCA withholding tax. This includes branches of an IGA FFI which operate outside of the IGA jurisdiction, since the coverage of an IGA extends only to operations in a particular territory.

Practice Point

FFIs subject to privacy and data protection laws are faced with a dilemma: either suffer the 30% FATCA withholding tax on withholdable payments or avoid investments that generate withholdable payments. In addition to that, not meeting the requirements set forth in local banking secrecy, privacy and human rights legislation exposes FFIs potentially to civil liability and supervisory sanctions. In some countries directors may even be held liable individually if the FFI violates local law while complying with FATCA.

In order to be able to comply with the requirements set forth in FATCA, we advise FFIs to map the legal risks and barriers in each jurisdiction in which an FFI conducts business. Allen & Overy could be of assistance in providing an FFI with detailed information on data protection, banking secrecy and human rights law in all jurisdictions in which an FFI conducts its business. Furthermore, Allen & Overy could assist in implementing FATCA in a manner consistent with local law. In some countries, for instance, an FFI could mitigate FATCA compliance issues by obtaining consent of the client, if the consent meets particular requirements.

In conclusion, FATCA implementation, due to its scope, could lead to complicated dilemmas and substantial risks. The implementation of FATCA is not straightforward. Compliance with FATCA will require thorough insight into its mechanisms and relevant local laws and regulations.

Circular 230 disclosure: To ensure compliance with requirements imposed by the Internal Revenue Service, we inform you that the U.S. federal tax discussion contained herein (1) was not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal tax-related penalties under the Internal Revenue Code and (2) was not written to support the promotion or marketing of any transaction. Taxpayers should seek the advice of their own independent tax advisers based on their own particular circumstances.