Congressional Tax Proposals May Significantly Impact the Global Financial System

By L Wayne Pressgrove, Jr, US Tax Lawyer, King & Spalding, Atlanta, and John C. Taylor, US Tax Lawyer, King & Spalding LLP, London (03/02/2010)

On 9 December  2009, the United States (US) House of Representatives passed the Tax Extenders Act of 2009 (the Act). Title V of the Act is notable because it incorporates the key provisions of the Foreign Account Tax Compliance Act of 2009 (the Fat Cat Provisions). The Fat Cat Provisions were jointly developed with key Democrats in both Houses of Congress in consultation with the US Treasury Department. The Obama administration publicly supports these provisions. It is anticipated that the Act will be passed by the Senate sometime this year.

The Fat Cat Provisions would affect foreign financial institutions and investment funds that invest in or otherwise deal with US equity or debt securities (including US government securities) or that have any US individual taxpayers (US citizens or residents, including ‘green card’ holders) as direct or indirect investors or lenders. If enacted, the Fat Cat Provisions are likely to have more of an impact on the global financial system than any US tax law change in more than a decade.

Expansive Scope

Although touted by Congress and the Obama Administration as anti-offshore tax evasion legislation, the Fat Cat Provisions will have a significant effect well beyond US persons engaging in tax evasion and their facilitators. It is unclear whether the provisions would reduce offshore tax evasion but it is certain that the Fat Cat Provisions would impose significant burdens upon the global financial system in an attempt to achieve this goal.

One of the Act’s most significant and under-reported provisions is its expansive definition of a ‘financial institution’ to include most private investment funds. A foreign financial institution is defined by the Fat Cat Provisions to include:

  • a foreign bank;
  • a foreign custodian or depositary; or
  • a ‘foreign investment entity.’

A foreign investment entity includes any entity engaged primarily in investing or trading in securities, partnership interests, commodities or interests in any of the preceding.

Many private equity, venture capital and hedge funds formed outside of the US would be ‘foreign financial institutions’ under the Act’s definition. An entity is treated as foreign for this purpose if it is not formed under the laws of the US, even if the fund’s investment managers are located within the US.

New Withholding Tax

The cornerstone of the new third-party information reporting initiative is the imposition of a 30 per cent withholding tax on ‘withholdable payments’ made to a foreign entity. A withholdable payment includes all US source fixed, determinable, annual or periodical income (‘FDAP’) and any gross proceeds from the sale of property that can produce US source interest or dividends. The definition greatly broadens the tax that may be imposed on foreign banks. Interest that would otherwise qualify for the ‘portfolio interest’ withholding exemption is subject to withholding under this provision. Similarly, the gross proceeds, not just the net gain, realised from the sale of property giving rise to dividend or interest income will be subject to this withholding tax. These are significant changes from current US federal tax law where portfolio interest and capital gains realised by a foreign person are generally exempt from US federal withholding taxes.

Current withholding tax provisions would be amended to prevent a duplication of US withholding taxes in case of an overlap with the new withholdable payments tax. In certain cases, a beneficial owner may be entitled to a refund or credit for any taxes withheld under this new provision.

Application to Financial Institutions

The withholding tax applies to any withholdable payment made to a foreign financial institution unless the institution enters into an agreement with the Treasury, described below (‘Treasury Agreement’). The Treasury Agreement will generally require the financial institution to:

  • obtain information regarding each account holder in order to determine whether the account holder is a US person meeting certain requirements or has US persons as substantial owners (‘US accounts’);
  • comply with due diligence and verification procedures mandated by the Treasury;
  • report the identities, account balances and account transaction activity for certain US accounts; and
  • deduct and withhold 30 per cent from any ‘passthru payment’ made to certain persons.

Passthru payments are those made by the foreign financial institution to:

  • an account holder who fails to provide certain identifying information;
  • an account holder that fails to waive any provision of foreign law that would prevent reporting of the holder’s information to the US government;
  • a payment made to another foreign financial institution that has not entered into a Treasury Agreement; or
  • a payment made to another foreign financial institution that elects to have the payments be subject to the 30 per cent withholding tax.

Some of the reporting obligations can be replaced with IRS Form 1099 reporting if the Treasury allows the foreign financial institution to do so. In either case, the financial institution must agree to comply with any request by the Treasury for additional information relating to the withholdable payments. The requirements imposed by the new Treasury Agreement are in addition to any requirements imposed under the Qualified Intermediary program.

The Act defines the term ‘US account’ as any ‘financial account’ which is held by one or more ‘specified US persons’ or ‘US owned foreign entities.’ The Act defines the term ‘financial account’ as any depositary or custodial account or, unless otherwise excluded by the Treasury, any equity or debt interest in the financial institution itself. Equity or debt interests in the financial institution itself are treated as a financial account maintained by the financial institution for this purpose, but are not treated as a financial account if such interests are regularly traded on an established securities market. Thus, an equity holder in, or lender to, a private equity fund should be an account holder with a foreign financial institution for this purpose.

A ‘specified US person’ is any US person other than certain types of entities, such as corporations with regularly traded equity, tax-exempt organisations, banks, mutual funds and real estate investment trusts. The Act also defines the term ‘US owned foreign entity’ as any foreign entity what has one or more ‘substantial US owners.’ A foreign entity has a substantial US owner if any specified US person owns, directly or indirectly, more than 10 per cent of the entity’s equity. In the case of foreign corporations, the threshold is measured by vote or value, and in the case of foreign partnerships, the threshold is measured by profits or capital interests. No minimum ownership threshold by specified US persons applies if the entity is a ‘foreign investment entity.’ Most investment funds, including hedge funds and private equity funds, should be treated as a ‘foreign investment entity’ for this purpose. Therefore, a foreign investment fund has a substantial US owner if it has any specified US persons as direct or indirect owners. It is unclear how indirect ownership will be measured.

The Treasury Agreement can potentially conflict with local law. For example, if foreign law would prevent any information from being provided to the Treasury pursuant to the Treasury Agreement, the financial institution is obligated to either obtain a valid waiver of such law from each account holder or, if this is not possible, to close the affected account.  This may not be possible because some countries do not allow customers to waive privacy laws. The definition of an account is very broad and includes items such as non-publicly traded debt or equity. Because this expansive definition would catch non-publicly traded debt or equity, an issuer may be contractually unable to close such an account (ie, redeem the debt or equity).

The new withholding tax does not apply to withholdable payments made to a foreign financial institution if the beneficial owner of such payment is an excluded person. Excluded persons include foreign governments, political subdivisions or instrumentalities of a foreign government, certain international organisations, and foreign central banks. In addition, the Treasury has authority to exclude other classes of persons or certain financial institutions from withholding if the Treasury determines that such class poses a low risk of tax evasion. A foreign financial institution may be eligible for this exclusion if it does not have any US accounts and meets certain other ongoing requirements.

The imposition of the new withholding tax is meant to force a large cross-section of the global financial system to comply with the Act’s information reporting obligations. If a foreign financial institution does not enter into the Treasury Agreement, all withholdable payments made to that entity are subject to the 30 per cent withholding tax. The tax is not limited to payments made or otherwise attributable to certain account holders at the financial institution such as specified US persons. Thus, any foreign entity classified as a financial institution by the Act may need to enter into a Treasury Agreement in order to avoid the 30 per cent withholding tax on any US investments even if the entity currently has no US account holders.  

Other Foreign Entities

The new withholding tax also applies to any withholdable payment made to a foreign non-financial institution entity unless certain certification requirements are satisfied. If the beneficial owner is the recipient entity or a non-financial institution foreign entity, the beneficial owner must provide the withholding agent with either:

  • certification that the entity does not have any direct or indirect substantial US owners; or
  • the name, address and tax identification number for each substantial US owner.

A withholding agent must report the above information with respect to specified US persons to the Treasury.

The requirement to withhold does not apply if the beneficial owner is an excluded entity. Excluded entities include corporations with regularly traded equity, foreign governments and their instrumentalities, central banks and any other class of persons identified by the Treasury as excluded entities. Additionally, the Act grants the Treasury authority to exempt any class of payments identified as posing a low risk of tax evasion.

Effective Date

This provision generally would apply to payments made after 31 December 2012. Because of the significant issues involved in implementing this provision, this effective date may be very optimistic. When the original Qualified Intermediary rules were introduced, their effective date was pushed back several times due in part to the complexities of implementation. Tax practitioners are already pushing for Congress to allow the Treasury to extend the effective date by regulation so that both the Government and taxpayers will have adequate time to properly implement this novel and complex regime.