FATCA: Implications for Trusts and Trustees

The Foreign Account Tax Compliance Act (FATCA) provisions enacted as part of the Hiring Incentives to Restore Employment (HIRE) Act of 2010 will result in unprecedented new client identification, disclosure and withholding obligations for virtually all non-US financial institutions (FFIs) and non-US non-financial entities (NFFEs) that wish to retain access to the US capital markets.

While much of the focus has been on non-US banks and investment funds, FATCA will also affect virtually all non-US trust companies and many family trusts and family investment vehicles.

FATCA will impose a new withholding tax of 30 per cent on US source dividends, interest, and various other ‘fixed, determinable, annual or periodic’ payments as well as gross proceeds from the sale or disposition of assets that generate such payments (such as sales of US stock). This withholding tax will apply to payments by FFIs that do not comply with certain identification and information reporting requirements regarding their US accountholders (including certain US owners of non-US entities such as trusts and companies), and to NFFEs that do not report certain information directly to US withholding agents, subject to significant exceptions under both the final regulations released on January 17 2013 (the ‘Regulations’) and new bi-lateral intergovernmental agreements (IGAs).

What do Trust Companies Need to Do Now?

Non-US trust companies and corporate service providers will need to evaluate the FATCA reporting status of each trust or company for which they act in order to determine: (i) what the US classification of each trust or company is (ie, grantor or non-grantor trust, corporation, partnership, or disregarded entity); (ii) which entities are FFIs and which are NFFEs, and (iii) which are subject to the Regulations and which are covered by IGAs.

As a threshold matter, trust companies and service providers will need to determine whether they wish to act as ‘Sponsoring’ FFI and report information on behalf of ‘Sponsored’ trusts and entities.

Trust companies will then need to implement appropriate changes to their on-boarding and customer relationship management systems, processes, and procedures and validate the required changes to their existing AML/KYC procedures in order to ensure that the required due-diligence procedures are in place to allow them to identify any US persons that are either ‘controlling persons’ or meet certain thresholds of beneficial ownership in the trust (or underlying entity), which thresholds and definitions may vary depending on whether the entity is an FFI or an NFFE and on whether the entity is in an IGA jurisdiction.

The ‘Sponsoring/Sponsored FFI’ Approach

Under the Regulations, certain FFIs may elect to assume the FATCA due diligence, verification, withholding, and reporting obligations of other FFIs which they manage, and which they exercise a requisite degree of authority to manage under a contractual relationship.

Therefore, trust companies may choose to ‘sponsor’ the trusts and underlying companies held by the trusts for which they act as trustee, perform the reporting and other obligations that these entities would have had under an FFI Agreement, and retain documentation with respect to the sponsored entities for six years.

To be eligible to be sponsored, however, a trust must not hold itself out as an investment vehicle for unrelated parties and must have at most 20 individual owners of its debt and equity, so only smaller trusts will be eligible for this approach. The sponsored trusts will not themselves need to register with the IRS; however, the trust company will need to register as a ‘Sponsoring’ FFI, obtain an identification number (GIIN) and designate the entities it wishes to sponsor.

Service providers may also choose to act as sponsor for certain ‘registered deemed compliant’ entities that have registered with the IRS as satisfying the criteria for deemed-compliant status, and in such case the twenty person ownership limitation applicable to Sponsored FFIs should not apply.

Owner Documented FFI Status

Although the sponsoring/sponsored FFI approach discussed above will likely be preferable in most cases where it is applicable, there are some circumstances in which a trust or company may not be eligible to be sponsored.

For example, it appears that certain trusts that have an individual trustee may still be considered investment entities under the Regulations where an entity is acting as the investment advisor; however, such investment advisor’s contractual mandate may not rise to the requisite level of control over the trust to grant it the authority to act as a Sponsoring FFI. In addition, the 20 owner limitation or restrictions applicable to CFCs may limit the utility of this approach.

Moreover, in certain limited cases, such as perhaps in connection with certain foreign grantor trust structures, the trustees may determine that the ‘Owner Documented FFI’ (ODFFI) approach might achieve a better result from a privacy standpoint, although because this approach applies on a withholding agent by withholding agent specific basis, it may be administratively more complex.

Under this approach, withholding agents and qualified intermediaries may agree to collect and report information regarding trusts that are classified as FFIs but that provide information and documentation regarding their owners (or that provide a letter from a US law or accounting firm certifying that the trust has no US beneficial owners or providing an owner reporting statement and withholding certificates for the US owners).

Classification of Trusts under the Regulations

Under the Regulations, certain trusts and family owned investment entities that primarily hold financial assets (and therefore might potentially have been FFIs), generally should instead be categorised as NFFEs provided the trustee and investment advisors are individuals; however, trusts and companies that are managed by an entity such as a trust company will generally be FFIs unless the trust in question primarily holds assets that are non-financial in nature.

Therefore, trusts that directly hold tangible assets (eg, real estate, art, airplanes and yachts) may escape classification as FFIs under the regulations even if they are managed by a trust company or an entity acting as investment advisor. However, trusts that primarily invest in securities, funds, commodities, and derivatives will generally be FFIs if the trustee is a trust company (as opposed to an individual trustee), or if an entity is acting as the investment advisor (eg, a bank). Moreover, even where the trust primarily holds tangible assets, if these are held through an underlying holding company or partnership, rather than directly, this would also generally result in the trust being deemed to primarily hold financial assets (eg, stock and partnership interests).

This is important because the compliance burden differs significantly depending on whether an entity is an FFI or an NFFE. NFFEs must generally only either certify to US withholding agents that they have no substantial US owners or provide the name, address, and US taxpayer identification number of each such substantial US owner, whereas FFIs (unless they are ‘Model 1 IGA’ FFIs) must enter into an FFI Agreement, comply with extensive due diligence and verification requirements, and provide substantial additional information to the IRS.

On a case-by-case basis, however, certain trusts may prefer from a disclosure and confidentiality standpoint to be classified as an FFI rather than an NFFE, as this may actually require less information regarding the trust’s assets (eg, foreign grantor trusts of which US persons are discretionary beneficiaries currently receiving distributions from the trust, particularly where such trusts may be eligible to ‘owner document’ as discussed below).

Ownership Attribution Thresholds under the Regulations

Under the regulations, a ‘substantial US owner’ of an NFFE, including a trust classified as an NFFE, includes US persons treated as the grantor and any beneficiary treated, including under certain attribution rules, as owning a 10 per cent or greater interest in the trust.

Subject to certain de minimis exceptions, this includes (i) a US beneficiary of a discretionary trust who receives distributions the value of which exceeds either 10 per cent of the trust’s income or assets; (ii) a US beneficiary entitled to receive mandatory distributions where the actuarial value of their interest in the trust exceeds 10 per cent of the trust’s assets; or (iii) a US beneficiary who receives both mandatory and discretionary distributions where the 10 per cent ownership threshold is met under a combined test. Contingent and remainder beneficiaries who are not currently receiving distributions are not viewed as having a present interest in the trust and their interests are not counted for the purposes of the above ownership attribution tests.

If, however, a trust is classified as an investment entity, and therefore an FFI rather than an NFFE, due to primarily holding financial assets and being managed by an entity that provides financial services, then unless a US person is the grantor of the trust (in which case that US grantor would be treated as owning the trust), a zero per cent threshold will apply in determining reportable ownership by US beneficiaries, and even small mandatory distribution interests or distributions from the trust would generally result in a reporting obligation with respect to that US beneficiary’s interest in the trust.

Classification under IGAs and Varying Treatment Depending on Jurisdiction

Trusts and family investment entities covered by an IGA, where the definition of the term ‘investment entity’ is determined consistently with the FATCA Partner’s interpretation of the FATF guidelines, may potentially be categorised as NFFEs under a different (and in some respects broader) test than under the Regulations. For example, it appears that under the UK’s interpretation of the term most family trusts and family investment entities would escape classification as ‘investment entities,’ and therefore presumably would be NFFEs regardless of whether they are managed by a trust company or an entity acting as an investment advisor to the trust.

Depending on the FATCA Partner’s interpretation of the FATF guidelines, in the case of determining whether a US beneficiary is a substantial US owner of a trust, a 25 per cent beneficial ownership threshold may apply, whereas the Regulations impose a 10 per cent (or potentially, with respect to certain trusts treated as investment entities, a zero per cent) beneficial ownership threshold.

IGAs also deviate from the approach initially adopted in the proposed FATCA regulations by introducing a new concept of ‘controlling persons’ (defined to mean natural persons who exercise control over an entity), into the test for determining whether an account should be categorised as having US owners. In the case of a trust, the category of controlling persons includes US individuals who are settlors, trustees, protectors, and beneficiaries (to be interpreted consistently with the FATCA Partner country’s interpretation of the FATF recommendations).

Although the Model 2 IGA defines certain key terms affecting the due diligence process by reference to the Regulations, the Model 1 IGA permits, but does not require, FFIs to elect to apply the account due diligence procedures under the Regulations rather than those specified in the IGA, and even then permit this only if the FATCA Partner allows them to do so.

Classification of Trusts and Entities for US Tax Purposes

The US tax classification of entities will affect whether trust companies and offshore service providers may assume FATCA reporting responsibility under the ‘Sponsoring/Sponsored FFI’ framework discussed above, insofar as in the case of certain corporations (as opposed to entities classified as partnerships or disregarded entities for US tax purposes) that are ‘controlled foreign corporations’ (CFC), the Regulations limit who may act as ‘Sponsoring FFI’, and would generally not permit a non-US trust company or service provider to act as Sponsoring FFI.

The classification of trusts for US tax purposes will also impact the analysis, and may limit options and/or result in advantages or disadvantages to one approach or another (eg, owner documented FFI vs Sponsored FFI or FFI Agreement) with respect to the FATCA compliance alternatives appropriate for particular structures. Therefore, it will be essential to determine whether trusts are: (i) regarded as trusts or business entities based on applicable US tax principles; (ii) whether trusts are classified as ‘grantor’ or ‘non-grantor’ trusts.

Grantor trust status may also inform the decision as to preferred FATCA compliance approach with respect to particular structures, as US individuals who are treated as the grantor of a non-US trust will always be reportable as a US owner of a trust, regardless of whether it is classified as an FFI or an NFFE; however, where a US person is reported as the grantor this may result in reduced reporting requirements with respect to other US persons who are beneficiaries.

Therefore, both the classification of trusts as FFIs or NFFEs and the due diligence and reporting requirements associated with such entities, potentially including applicable ownership reporting thresholds as well as whether ‘controlling persons’ must be reported will vary depending on: (i) whether the trustee or investment advisor is an individual or a company; (ii) whether the trust primarily holds financial or tangible assets; (iii) whether the trust or underlying companies are covered by an IGA or under the Regulations, and (iv) if under an IGA, which IGA applies as requirements may vary from one IGA jurisdiction to another depending on that jurisdictions interpretation of certain FATF guidelines.

Because these due diligence and reporting requirements can also vary depending on whether a trust is treated as a grantor or non-grantor trust, and can potentially affect eligibility for the Sponsored/Sponsoring FFI approach, trust companies and service providers will also need to implement procedures to determine the US tax classification of trusts and companies as part of their FATCA compliance projects.

Trust companies and service providers whose clients include trusts and companies, should bear the above factors in mind when designing their client on-boarding, due diligence and reporting systems, and must carefully consider which compliance approach would be best suited to different categories of trusts and trust structures.