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Foreign Entities Subject to Reporting Rules On Financial Accounts of U.S. Persons

The IRS has instated some very aggressive rules to force Foreign Financial Institutions and Non-Financial Foreign Entities to enter into FATCA agreements and fully comply with new strict reporting requirements on the assets and financial accounts of US persons. While the rules and strategies in this area of tax law have undergone a number of changes in the past few years, this is an area of tax law that I have been working in since the 1980’s under various offshore voluntary disclosure programs and initiatives as a San Diego tax attorney.

Under the rules governing the international tax reporting obligations of foreign entities with financial accounts of U.S. person, a “withholding agent” paying U.S. source interest, dividends, rents, royalties or making a “withholdable payment” in any other form to a “foreign financial institution” (FFI) must withhold tax equal to 30 percent of the amount paid unless the FFI has entered into a FATCA agreement with the IRS. Under the statute, the terms involved have particular and specific definitions.

Foreign Financial Institutions and Non-Financial Foreign Entities

The regulations require foreign financial institutions (FFI) and other nonfinancial foreign entities (NFFEs) to provide information about accounts and interests held by U.S. persons. As defined by the code, a “financial institution” is an entity that meets certain requirements. To be considered a financial institution, an entity must do one of the following: 1) “accepts deposits in the ordinary course of a banking or similar business”; 2) “holds financial assets for the account of others as a substantial portion of its business”; 3) participates “primarily in the business of investing, reinvesting, or trading in” securities, partnerships, commodities, or interests of any of those items. Institutions falling into these categories may include banks and similar institutions, as well as “broker-dealers, clearing organizations, trust companies, custodial banks, and entities acting as custodians with respect to the assets of employee benefit plans.”

The third category of financial entities includes hedge funds, private equity funds, venture capital funds, and mutual funds. The primary consideration for whether an entity falls into Category 3 is if its primary business is investing, reinvesting, and trading in securities and similar items, which is typically a “fact-specific” inquiry.

For these purposes, the term “security” includes corporate stock, interests in “widely held or publicly traded” partnerships and trusts, debt instruments, any “derivative financial instrument in” any of those items. Similarly, the term “commodities” has a specific definition and includes commodities that are “actively traded,” notional principal contracts and other derivative financial instruments with respect to such commodities, and certain positions held as hedges of commodity holdings.

To be considered an FFI, a foreign account must be a “foreign entity,” which is described by the statute as corporations and partnerships organized under the laws of any jurisdiction other than the United States, a U.S. state, or the District of Columbia. A foreign entity that is not an FFI is considered to be an NFFE (Non-Financial Foreign Entity).

The Withholding Rules for Foreign Entities

Under the rules passed by Congress, payors must withhold tax at 30 percent from most payments made to foreign entities by U.S. sources. The payments subject to the withholding rule include interest, dividends, and royalties. It also applies to items that might not normally be subject to U.S. tax, such as portfolio interest and capital gains of foreign interest. This rule essentially means that a foreign entity holds U.S. investments, it must provide information to the IRS about its U.S. clients, or else pay a 30 percent withholding tax on those U.S. investments. If an FFI wishes to escape the withholding requirement, it may do so only by entering into an agreement with the IRS under which it reports to the IRS information about accounts of U.S. persons. NFFEs can avoid paying the withholding tax by providing information to U.S. withholding agents about U.S. persons involved with the NFFE.

What Agreements Can FFIs Enter Into with the IRS?

Some FFIs enter into agreements with the IRS to avoid to lessen the effects of the withholding rules. As stated above, FFIs can agree to turn over information to the IRS about its U.S. investors, it will not be subject to the withholding rules. Also, FFIs can agree to become qualified intermediaries (QIs), which requires the foreign entity to collect documentation from its clients sufficient to establish the clients’ status for the purposes of withholding under IRC sections 1441 and 1442. Under IRC §§ 1441 and 1442, persons and entities that make payments to foreign persons are required to withhold tax from items that come from U.S. sources, including dividends, interest, royalties, and other forms of fixed annual or periodic income. Under the QI agreement with the IRS, the FFI can also choose to withhold U.S. income tax on these items.

In accordance with Circular 230 Disclosure



William D. Hartsock has been successfully helping clients comply with U.S. International Tax Laws and deal with issues related to worldwide taxation since the early 1980s. Mr. Hartsock offers free consultations with the full benefit and protections of attorney client privilege to help people clearly understand their situation and options based on the circumstances of their case.

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