The Foreign Account Tax Compliance Act (FATCA, “the Act”) (which was part of the HIRE Act passed in 2010) contains a number of provisions that are intended to make it more difficult for U.S. taxpayers to use foreign accounts to shelter income from U.S. tax. It also imposes new requirements on certain foreign taxpayers with U.S. investments. Taxpayers with overseas connections are about to become subject to increased reporting requirements for their financial accounts, even if they are already U.S. tax-compliant and not part of the targeted group. Some of the new requirements are not immediately effective, but taxpayers should be aware of them before they come into force.
Mandatory Withholding on Foreign Accounts. Effective January 1, 2013, a U.S. entity that makes virtually any type of payment to a foreign financial institution will be required to withhold and remit 30% of the payment to the IRS. The types of payments subject to this requirement include interest, dividends, royalties, premiums, annuities, wages, and proceeds from the sale of property that can produce interest or dividends. The recipient foreign financial institution may avoid this 30% withholding by entering into an agreement with the IRS to identify all of its account holders who are U.S. taxpayers and providing such identifying information to the IRS. The delayed effective date is designed to give the IRS sufficient time to establish a program under which foreign financial institutions may enter into agreements to avoid the 30% withholding. You should begin to contact any foreign financial institutions with which you do business, to determine whether they intend to enter into an agreement with the IRS, or if it will be necessary for you to withhold on payments made to them.
Repeal of Foreign Exceptions to Registered Bond Requirement. In 1982, the United States curtailed the use of “bearer” (i.e., unregistered) bonds by U.S. taxpayers, because they could be too easily used for tax evasion purposes. An exception was made for certain bonds held by non-U.S. taxpayers, but the IRS found that this exception was also subject to abuse. As a result, the Act denies an interest deduction for interest paid on any unregistered bond, effective for bonds issued after March 18, 2012. Disclosure of Foreign Financial Accounts. The Bank Secrecy Act requires that U.S. taxpayers file an annual report with the U.S. Treasury of any foreign financial accounts with an aggregate value of more than $10,000 at any time during the year. This is commonly known as the “FBAR” requirement. The Act, for the first time, makes this requirement part of the Internal Revenue Code, thereby transferring to the IRS the authority to both interpret and enforce this provision.
Beginning in tax years starting after March 18, 2010 (which means 2011 for most taxpayers), the Act also requires all U.S. taxpayers with an interest in a “specified foreign financial asset” to attach a statement to their income tax return each year in which the aggregate balance of their foreign financial assets exceeds $50,000. The information to be reported on this statement is similar to the information required on an FBAR, but it is more expansive, as the definition of “specified foreign financial asset” is broader than that of a foreign financial account under the FBAR rules.
There will be extensive overlap between the information reported on FBARs (filed separately from the annual income tax return) and that reported on the specified foreign financial account statement (attached to the tax return). However, situations exist where a foreign asset may be required to be reported on an FBAR but not the disclosure statement (i.e., if the aggregate balance of foreign financial accounts exceeds $10,000 but not $50,000) or vice versa (i.e., if the taxpayer has specified foreign financial assets which are not held in a financial account).
Penalties for Failure to Disclose Foreign Accounts. In addition to the new reporting requirements, the Act imposes new penalties for both the failure to disclose a foreign financial account and for any understatement of tax that results from an undisclosed foreign financial account. There is a $10,000 penalty for taxpayers who fail to file the disclosure statement. If the taxpayer still does not file the disclosure statement after being notified by the IRS, additional $10,000 penalties can apply, up to $50,000 per year. Other penalties may also apply. These penalties will make it very costly for taxpayers who conceal income generated by foreign accounts.
Extended Statute of Limitations for Undisclosed Foreign Accounts. The IRS normally has three years in which to audit a tax return after it has been filed. The Act extends that period to six years in the case of certain unreported income from a foreign financial account.
Increased PFIC Reporting. The Act imposes new reporting requirements for passive foreign investment companies (“PFICs”). A PFIC is a foreign corporation that generates passive income (i.e., interest and/or dividends) and is often used as an investment vehicle. Foreign mutual funds and hedge funds are usually PFICs. The government is concerned that U.S. taxpayers are not properly reporting their PFIC income, and the Act requires that U.S. taxpayers who are PFIC shareholders file an annual report with the IRS.
Foreign Trust Enforcement. Due to concerns that U.S. taxpayers are using foreign trusts to avoid U.S. tax, the Act makes a number of changes in the rules governing foreign trusts. Under prior law, a foreign trust was subject to U.S. tax if it was established by a U.S. taxpayer and it had a U.S. beneficiary. The Act expands the classes of persons considered trust grantors and beneficiaries, thereby bringing more foreign trusts under U.S. tax jurisdiction. The Act also requires that any person who is taxable as the owner of a foreign trust must provide such information about the trust as the IRS may require. It backs up this requirement with stiff new penalties.
Taxation of Dividend Equivalents. Dividends paid by U.S. corporations to foreign individuals and entities are generally subject to a 30% withholding tax, although that tax rate is sometimes reduced by an applicable tax treaty between the U.S. and the resident country of the recipient. Foreign shareholders have attempted to avoid the withholding tax by taking “dividend equivalents,” such as securities lending transactions, sales-repurchase agreements, or notional principal contracts, in lieu of actual dividends. The Act makes it clear that such dividend equivalents are to be treated as U.S.-source dividends for tax purposes.
This legislation is part of recent attempts by Congress to make it more difficult for U.S. taxpayers to avoid tax on overseas accounts. You should begin a review of your overseas financial affairs to ensure that you are in compliance as the provisions of FATCA come into effect. If you would like assistance with that effort, or if you have any questions related to this article, please feel free to contact our Tax Director, Dale Mason, at email@example.com or at 703-502-9500.
This newsletter is for informational purposes only. It should not be construed as tax, legal, or investment advice. Information has been gathered from sources believed to be reliable, but individual situations can vary and you should consult with your investment, accounting and/or tax professional.
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