FATCA: Should U.S. Financial Institutions Be Concerned?

By Ryan Dudley, Friedman LLP, New York, NY

Editor: Stephen E. Aponte, CPA

Foreign Income & Taxpayers

The tax community is currently awaiting IRS guidance on some of the most globally penetrating tax legislation the U.S. government has ever passed: the rules under the Foreign Account Tax Compliance Act (FATCA).

Following the discovery of so many previously undisclosed foreign bank and securities accounts as part of the Foreign Bank and Financial Account Report Voluntary Disclosure Program that ended October 15, 2009, Congress enacted FATCA to force foreign financial institutions to identify U.S. account holders and reveal details about their accounts to the IRS. The legislation, as drafted, requires foreign financial institutions to potentially collect an enormous amount of information about both their U.S. and foreign customers to share with the IRS or face a harsh 30% withholding regime on a wide range of U.S.-sourced receipts.

Some relief from these broad reporting requirements is expected through the regulations, but it is not clear whether such regulatory relief will be sufficient to prevent the FATCA reporting regime from being more onerous than the reporting requirements currently imposed on U.S. financial institutions. Once FATCA is in place, other countries are likely to adopt similar reporting regimes. This raises questions about the potential reporting obligations U.S. financial institutions will be facing in the years to come.

Legislative Background

FATCA was proposed in 2009 and was subsequently incorporated into the Hiring Incentives to Restore Employment (HIRE) Act of 2010, P.L. 111-147, which was signed into law on March 18, 2010. In order to allow financial institutions to modify their systems and potentially communicate the changes to the existing customer base, the FATCA provisions (Secs. 1471–1474) will take effect from January 1, 2013.

Withholding Regime

In broad terms, FATCA requires any person in control or possession of a “withholdable payment” to be made from the United States to a foreign “financial institution” (and certain other foreign entities) to withhold 30% of the withholdable payment and remit it to the IRS.

A financial institution is an entity that accepts deposits in the ordinary course of a banking or similar business, holds financial assets on account for others as a substantial portion of its business, or is engaged in investing or trading in securities (Sec. 1471(d)(5)). This definition would presumably include banks, savings institutions, insurance companies, investment companies, and hedge funds.

Withholdable payments include interest, dividends, and other fixed or determinable annual or periodic gains, profits, and income that are sourced in the United States (Sec. 1473(1)(A)). Withholdable payments also include the gross proceeds from the sale or disposition of property of a type that produces U.S.-sourced interest or dividend income—i.e., application of the withholding tax would not be limited to the income and gain. The withholding applies regardless of whether the withholdable payment would otherwise be sheltered by a tax treaty. Such a regime would effectively make trading in U.S. securities economically impossible for any foreign financial institution.

Reporting Regime

To avoid the application of FATCA’s withholding tax provisions, a foreign financial institution must enter into an information disclosure agreement with Treasury and obtain sufficient information about each of its accounts to determine whether the account holder is a U.S. person or a foreign entity with a substantial U.S. owner. A foreign entity will have a substantial U.S. owner if it is more than 10% owned by a U.S. person or is a collective investment vehicle (e.g., a hedge fund) and a U.S. person owns any interest in the entity (i.e., the 10% rule does not apply).

In relation to accounts held by U.S. persons and foreign entities with substantial U.S. owners, both known as U.S. accounts, the foreign financial institution must collect information about the U.S. account holders, including the U.S. person’s name, account number, and tax identification number, and annually report to the IRS the account balance and gross receipts and payments/withdrawals from the account (Sec. 1471(c)). The foreign financial institutions must also agree to withhold 30% of all passthrough payments to a “recalcitrant account holder” or any other foreign financial institution that has not entered into an information disclosure agreement with Treasury.

A recalcitrant account holder is any account holder that fails to provide the information that the foreign financial institution requires in order to meet its obligations under the information-sharing agreement with Treasury (Sec. 1471(d)(6)(A)). Where the account is protected by bank secrecy laws, it will be classified as a recalcitrant account if the holder does not waive bank secrecy rights (Sec. 1471(d)(6)(B)). Note that an account in a foreign bank may now be subject to U.S. withholding tax simply because the account holder refuses to provide information to the foreign financial institution or waive his or her rights to bank secrecy even though the account holder may have no nexus in the United States.

As an alternative to agreeing to report account holder information to the IRS, a foreign financial institution subject to bank secrecy laws may agree to take steps to ensure that it has no U.S. accounts and to close any it may have previously opened (Sec. 1471(b)(1)(F)).

Adoption of FATCA by Foreign Tax Authorities

The United States is not the only country that has identified significant tax revenue losses due to its tax residents’ hiding money in offshore bank and financial accounts. Across Europe there has been debate about various countries’ bank secrecy laws. Germany has even paid for information (that may have been obtained illegally) about its residents’ foreign bank accounts. However, the United States is unique in the depth of its capital markets, the breadth of its consumer base, the role of its currency as the global reserve, and its central role in the global political and commercial environments. If any other country attempted to independently introduce a regime like FATCA, the financial community might simply cut that country off from the global financial markets. All the significant foreign financial institutions transact with U.S. counterparties and U.S. markets, so ring fencing the United States is not an option. Hence, most large foreign financial institutions are expected to comply.

Once a foreign financial institution agrees to report under FATCA, there will be a significant cost associated with the introduction of a system that involves questioning the tax residency and tax status of its customers, collating the data, and reporting it to the IRS. However, once the initial setup is complete, extending the questioning and reporting of the information to other countries should be a minor incremental progression. This fact has not been lost on Treasury. As early as 2009, Treasury officials were speaking about other countries’ introducing similar regimes to identify bank and financial accounts owned by their tax residents. If the FATCA regime were to be adopted in other countries, it would validate the U.S. law and reduce resistance from countries that might otherwise view the U.S. actions as an intrusion on their sovereign domains.

There is one significant implication for U.S. financial institutions if other countries adopt FATCA. U.S. financial institutions are not currently subject to FATCA and merely need to obtain W-8 forms (generally Forms W-8BEN, Beneficial Owner’s Certificate of Foreign Status for U.S. Tax Withholding) from foreign investors to be kept on file. The amount of investigation that the domestic bank must undertake for tax disclosure purposes is relatively modest, and there is limited reporting. If other major developed economies of the world adopted FATCA, U.S. financial institutions would confront the same burdens currently being faced by foreign financial institutions.


Stephen Aponte is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.

For additional information about these items, contact Mr. Aponte at (212) 792-4813 or saponte@hrrllp.com.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.

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