US Withholding Tax

Practical Implications of QI and FATCA

R. McGill

• Publisher: Palgrave Macmillan
• Year: 2013
• ISBN:
  9781137317308
• Topic: Business
• Subtopic: Finanza d'impresa
• Index: Business

The US is the world's largest capital market. Its withholding tax system is also the most complex. This book is essential reading for investors and intermediaries trying to comply with US QI and FATCA tax regulations. It guides the reader through these complex regulations with simple and practical insights into how to meet these compliance burdens.

Introduction

Part I

The QI Regulations

What this book is about

This book is intended to be an explanation of the US withholding tax system as it applies, in a very practical sense, to non-US financial institutions and their customers.

It is also important to state what this book is not. Apart from the natural caveats found elsewhere, this book is not intended to provide (and should not be construed as providing) tax, legal or investment advice. Neither is it intended to be an exhaustive tax technical exposition of the entire US Internal Revenue Code (IRC).

For non-US financial institutions and for investors with bank accounts outside the United States (including both non-US investors and US investors), there are two major elements of the US IRC that this book addresses – Chapters 3 and 4. These chapters, their intent and practical consequences are the subject matter, and only subject matter, of this book. However, I’m making no attempt to go through every line in these regulations. I’m much more concerned in this book with getting the general message across. It will become clear as you read this book why that is. There is little point in going into that level of detail when most firms have not yet grasped the basics or even the larger picture.

Fundamentals

For those unfamiliar with IRC Chapters 3 or 4 and who are reading this book as a fundamental reference work, I provide the following top-level summary of both IRC Chapters.

Chapter 3 of the IRC is all about documentation, withholding, depositing and reporting US-sourced Fixed, Determinable, Annual or Periodic (FDAP) income payments made to non-US beneficial owners through non-US financial intermediaries. The procedural and compliance obligations of financial intermediaries in this model is set out based on whether they are qualified or not qualified. The tax withheld from non-US beneficial owners (payees) in this model is only on US-sourced FDAP income and is based on the nature and validity of appropriate documentation available to the financial institution (payor) on the pay date of the income.

Chapter 4 of the IRC, however, is all about soliciting and maintaining information and documentation about all account holders and investors in order to correctly identify and report the global income paid to accounts that are deemed to be ‘US’ for the purpose of the Foreign Account Tax Compliance Act (FATCA). The procedural and compliance obligations of financial institutions in this model are set out in Foreign Financial Institution Agreements (FFIAs) administered by the IRS and affect only those account holders who are either ‘US’ – leading to reporting of global income – or ‘recalcitrant’ – leading to reporting and a penalty assessment (or account closure) imposed on the account by the financial institution.

What is critical to understand, and will be described in detail in the following chapters of this book, is that both systems are ‘cascade’ in nature. This means that there are obligations at all levels and that non-compliance at any level is automatically visible to the IRS through compliance at the higher level, usually through information reporting.

What should be clear, even from these two brief descriptions, is that Chapter 3 and Chapter 4 are very different both in structure and purpose.

Practical v. tax technical

There are two other things to know about the content of this book and the way in which I’ve chosen to write it. First, it is written from a practical perspective, not a tax perspective – although the two may be difficult to distinguish at times, and I will try to ‘bring it back to reality’ as often as possible. Whatever the tax language may be, there is usually a practical consequence. In fact, there is usually more than one consequence, and many of these individually, in turn, interact with each other to create new and often unforeseen effects. For a financial institution, that may be a change in client on-boarding procedures, policies or entirely new processes such as tax information reporting. For an investor, it might be a new form they have to know about or the consequence of not filling in a form that they need to be aware of. Second, while many, but by no means all, of those on the receiving end of these regulations have a good command of English, these regulations aren’t actually written in English. They are written in ‘American tax technical’ language. This language can be difficult to master, and failing to understand it can have serious consequences.

I was also tasked, when thinking about how to structure this book, as to why I would want to include IRC Chapter 3 at all. Chapter 3, came into force on 1 January 2001, over ten years before this book was written (although I did write a book on this subject back then too). From outside the industry, one would naturally assume that, after over a decade of supposedly knowing what the ‘rules’ are, both financial institutions and investors would not only understand what they are supposed to do but would have taken steps to comply. Over the intervening years, you’d also naturally expect that compliance to these regulations would have been progressively automated and standardised to the point where a book on the subject would be, well, pointless. In practice, nothing could be further from the truth. It is true that Global Custodians and larger financial institutions have embraced the implications of Chapter 3. However, if you draw a line from Washington DC eastwards, the level of knowledge, understanding and compliance to Chapter 3, even after ten years, falls rapidly with distance. By the time you get to Asia, levels of understanding are very low; English (let alone ‘American tax technical’) is not the back-office language of choice, and thus levels of awareness, understanding and compliance are lower still.

Why is this important? First, it evidences a continuing need to explain Chapter 3 in practical terms that everyone can understand. The consequences of non-compliance to Chapter 3 (and 4) are very severe. To date, the IRS has had, at best, a fragmented approach to enforcing its own regulations. However, relying on ‘they’ll never find us’, ‘not getting caught’ or using ignorance as a defence is not a realistic risk-management strategy in today’s highly regulated financial environment. Second, I’ve so far not referenced Chapter 4. IRC Chapter 4 commenced on 1 January 2013, with transition rules extending the implementation period to 1 January 2017. Chapter 4 has substantially larger implications for non-US financial institutions and their customers than Chapter 3 does. So, my point is that if, after ten years, there is still a clear and present need to explain Chapter 3, unless we do explain it successfully, and in context to Chapter 4, then Chapter 4 will go the same way.

QI v. FATCA

I’ve mentioned language a couple of times so far, and language is one of my passions, particularly in the context of being clear and concise. This probably originated from my early science-based education, but I still find it a prevalent need in my consulting, educational and training work today. There are several aliases under which these two chapters are more commonly known by or referred to. Chapter 3 is commonly known as the ‘QI regulations’ or sometimes ‘1441’ or ‘1441 NRA’, a reference to the section of the code that applies. Equally, Chapter 4 is also commonly known as ‘FATCA’. The seeds of confusion and non-compliance are sown by these terms.

The ‘QI regulations’ is a reference to a principle of Chapter 3 in which a foreign (i.e. non-US) financial institution may choose, if it fulfils certain criteria, to engage in a contractual agreement with the IRS and thus become a ‘qualified intermediary’, or ‘QI’. However, the regulations themselves relate to the tax and reporting treatment of specific types of income sourced from the United States and paid to anyone residing outside the United States. The net result of the term ‘QI regulations’ is that (i) many financial institutions believe that because they haven’t signed a QI agreement with the IRS, they are not affected by the regulations and (ii) many investors believe that because they are not US residents, they aren’t covered by US tax regulations. Both are incorrect. The regulations are triggered by the receipt of US-sourced FDAP income. So, a financial institution receiving a payment of US-sourced income is subject to the regulations in full, irrespective of whether it has signed a QI agreement or not. All that changes are the procedures that follow from being either a QI or NQI (non-qualified intermediary). Equally, for example, a South African investor receiving US dividends to his online brokerage account operated by a European financial firm is subject to these US tax rules because the payment was sourced from the United States. Many rant against this ‘extra-territoriality’, but because the system is cascade and starts with a US withholding agent bank, the IRS has all the control it needs to enforce the regulations irrespective of where the beneficial owner is or where his or her account is located outside the United States.

‘FATCA’ does not, tax technically, exist at all. It did once, in draft form only, in 2009, as a Congressional Bill (HR 3933). However, that Bill never got passed. Its content, adjusted and amended, ended up in a different piece of US law known as Title V of the Hiring Incentives to Restore [American] Employment Act, or ‘HIRE’ Act, passed in March 2010. Unfortunately, FATCA sounds very much like ‘Fat Cat’ and is a reference to the distaste expressed by many in the US electorate for those rich Americans evading US taxes by holding their investments offshore and then failing to declare not just their US-sourced income but also their global income to these accounts. So, even though the original name has no reference point in current US law, it has stuck to the point where even the IRS uses the term in its communications. So, while, as a purist, I may not, and do not, like such loose terminology, I’m forced to use it in this book, because it has entered the industry’s lexicon.

On the subject of lexicons, it’s also important to note that there is one other area of potential misunderstanding that can occur between Chapters 3 and 4, and it’s best that I highlight this in the Introduction, although I will go into more detail later. A ‘financial institution’ to most ordinary people would include banks and brokerage firms, and to a large extent, that is also the implied meaning of the term in IRC Chapter 3. A payment of US-sourced income would typically be made from a US corporation (‘issuer’) through a US withholding agent bank to a foreign (non-US) financial institution, again typically a bank or broker who would have the status of either QI or NQI under the regulations and adopt the required procedures accordingly. Chapter 4, however, very specifically creates a new and wider definition of ‘financial institution’ whose purpose I will discuss in Part II of this book. This wider definition brings many funds, hedge funds, collective investment vehicles and the like into the definition of ‘financial institution’ and therefore places them under the Chapter 4 regulatory rules. So, for readers of t...

Table of contents

• Cover
• Title
• Introduction: Part I The QI Regulations
• Part II FATCA: Introduction
• Part III Related Global Tax Initiatives: Introduction
• Appendix 1 The QI Agreement
• Appendix 2 IGA Model 2
• Appendix 3 Template AI Agreement (TRACE IP)
• Notes
• Index