4 Things Banks Need to Know About FATCA in 2014

Congress passed the Foreign Account Tax Compliance Act in 2010 in an effort to prevent offshore tax abuses committed by U.S. citizens. This legislation has broad implications for foreign financial institutions. Among many other things, FATCA imposes reporting obligations on financial institutions, requiring them to disclose certain information to the Internal Revenue Service pertaining to U.S. account holders.

Although FATCA was passed nearly four years ago, many of the key requirements will not take effect until later this year. These requirements affect a broad cross section of stakeholders and policies within financial institutions including, but not limited to, client onboarding, investment banking, documentation, treasury and collateral management. Here's what global banks need to know about FATCA for 2014:

Registration. April 25, 2014, is the last day for foreign financial institutions to register if they are to appear on the IRS' first foreign financial institution list, scheduled to be published on June 2, 2014. The definition of a financial institution is quite broad under FATCA and encompasses any institution that accepts deposits in the ordinary course of a banking or similar business; holds financial assets for the account of others; or is engaged primarily in the business of investing, reinvesting or trading in securities. This broad definition means that, at a minimum, non-U.S. hedge funds, insurance companies, broker-dealers, investment vehicles and banks are subject to the legislation if they receive certain income arising from sources within the U.S.

The FATCA registration portal is a Web-based system that permits FIs to register their FATCA classification with the IRS completely online. According to the IRS, FATCA registration can be accomplished most efficiently and effectively through the online registration process. Concerns were raised by the Treasury Inspector General for Tax Administration's report alleging inadequate system security protocols and the untested nature of the information technology system. However, the online system is now active and registrations may be finalized on or after Jan. 1, 2014.

FATCA withholding begins. Assuming no further delays, beginning on July 1^st, 2014, the IRS will impose a 30% withholding tax on fixed, determinable, annual, periodical income payments to nonparticipating FFIs, noncompliant nonfinancial foreign entities and recalcitrant account holders with respect to nongrandfathered obligations. Noncompliant nonfinancial foreign entities are entities that, for example, failed to provide necessary documentation evidencing the U.S. or non-U.S. tax status of their owners. Multiple iterations of IRS forms, such as the W-8BEN, have been released which suggests the IRS may continue to augment forms and their associated regulations. To fully mitigate the risk associated with the changing regulatory environment, increased tax form collection efforts, form validation, and record retention will be needed within financial institutions as well as a thorough evaluation of existing systems and processes.

Repapering and carve-outs. FATCA already affects the way financial services firms do business, collect information and maintain customer records.  Moving forward, FATCA will continue to evolve and may even affect derivatives transactions with no connection to the U.S. by imposing the withholding of taxes. In dealing with U.S. clients, withholding agents should require signed W-9s from U.S.-exempt recipients to overcome a presumption of foreign status. Like many other aspects of FATCA, withholding agent is broadly defined and includes any person or entity having control over a withholdable payment. Papering of pre-existing clients and delivery of additional forms and certifications above those previously requested may be required. Counterparties may be reluctant to provide this information, as what specific documentation is needed is sometimes unclear.

As described in the International Swaps and Derivatives Association's letter to the Treasury dated Nov. 11, 2013, withholding on collateral, even for grandfathered products such as swaps traded based on underlying ISDA documentation, may pose concerns much earlier than anticipated. This is particularly true in the standard pooled collateralization context. The standard ISDA master agreement requires payers to gross-up payees for any indemnifiable tax. At a minimum, counterparties should consider carving out obligations to gross-up payments in ISDAs and other master agreements for amounts deducted pursuant to FATCA. 

Grandfathering and "material modification." Grandfathering rules, which eliminate FATCA withholding entirely for certain obligations, were recently extended to obligations outstanding on July 1^st, 2014. However, a "material modification" to an instrument after this date will cause it to lose its grandfather protection. Further guidance may be needed to analyze various scenarios regarding what could constitute a "material modification." However, generally, any economically significant change in legal right or obligation is considered a material modification. In a swaps context, for example, cross-default threshold amounts, credit support annex terms for collateral and other credit terms may frequently change. So might the addition or removal of funds under an umbrella master. Procedures may be required so that modifications to pre-existing client documentation or terms do not endanger a transaction's previously grandfathered status. 

Rani Karnik is an attorney consultant specializing in FATCA remediation and compliance for Clutch Group. Chris Cahn is associate director for compliance at Clutch Group.