In the last eighteen months we’ve conducted compliance reviews in five countries on twelve Tier 2 and Tier 3 financial institutions. Those compliance reviews have been to the US tax regulations known as QI and FATCA. So, we think we’re in a reasonably good position to start looking at trends, issues and contributing something back to the community.

Now, for those unfamiliar, QI is principally a taxation framework applying to recipients of US sourced income while FATCA is a tax evasion prevention and detection framework targeted at US Persons. Whilst of very different purposes, the US has attempted to converge these two in rather convoluted and sometimes conflicting ways. The financial services industry, in turn, has over-complicated its approach, ironically, by seeking to simplify operational compliance. We see this commonly where firms have chosen to wrap up their CRS obligations with their FATCA obligations – because both of these are tax evasion frameworks, while leaving things like QI to income processing departments, because it’s a taxation issue at payment level. While logical at one level, this is causing some unintended consequences.

Both frameworks serve very different purposes, but they share common principles and those principles overlap across the frameworks and interact within each of them. Those principles are (i) document (ii) withhold, (iii) deposit and (iv) report. Overarching these four principles are control and oversight provisions and/or certification provisions. Documentation in FATCA is to determine US status and reportability, while in Chapter 3 (QI) documentation is used to determine status, legal form, levels of disclosure and treaty claims. Withholding in FATCA is a penalty applied for failure to provide sufficient FATCA information, while in Chapter 3 it is generally about the taxation of US income under US tax treaties to non-US recipients. Depositing the tax is the same in both frameworks. Reporting in FATCA is about global income and account balances of US Persons, recalcitrants and NP-FFIs, while in Chapter 3 it is about reporting of gross US sourced income and tax withheld (with one notable exception – see below).

Holistic vs Non-Holistic Strategy

So, compliance strategy falls into one of two categories. One strategy, as mentioned, separates the operationalisation of these frameworks based on purpose. This is a non-holistic model in which different parts of the business dealing with FATCA can and do come up with different policies, procedures and even interpretations quite separate from others working on the very same principles in QI. The other, and I believe more effective strategy, is to recognise that while the purpose of the two frameworks may be very different, the underlying principles that essentially drive policy and more importantly on-the-ground procedure, are the same. The former gives rise to substantial cost duplication, inefficient use of resources and increased compliance risk. The latter, being a more holistic approach, removes most of these issues. What follows are two of the most common examples we have seen in our reviews. The first describes a situation where base reporting under FATCA is handled under Chapter 4 but penalties applied under FATCA are reported under the rules of Chapter 3. The second example illustrates where misinterpretation of the rules of suspension of FATCA penalties can lead to under-withholding in FATCA and mis-categorisation of tax in reporting. These two examples establish clearly the connectivity of FATCA and QI and the high risks of not handling them in a coordinated and holistic way.

First, at the payment event level, e.g. a US dividend distribution, the tax evasion rules of FATCA must be applied first in order to determine if there is a non compliance penalty to be paid. If there is no non compliance penalty to apply, the income taxation rules of US revenue code Chapter 3 are applied allowing the tax rate applicable to the income to be determined by the status and treaty entitlements (if any) of the recipient. So, at the payment level, this seems clear and unambiguous. However, both frameworks have control and oversight rules that include reporting. In the case of FATCA, that’s usually described as reporting of US persons performed using Form 8966 or its digital equivalent via the US ‘IDES’ system. In the case of Chapter 3, that’s performed using a tax return (Form 1042) and information reports (Forms 1042-S). Again, all seems simple and unambiguous. Except that if there is a FATCA penalty to apply, that has to be reported on forms 1042-S and 1042. In other words, while the primary reporting objective of FATCA is accomplished by sending information about US account holders to the IRS directly or indirectly, any FATCA penalty for non compliance is applied via the tax system and not as a separate penalty payment. Because of that, it becomes reportable on the same forms used for income taxation.

One False Step

I deliberately over-simplified the first example by implying that the only data reported in a FATCA report is about US account holders. It’s not. Any firm that cannot definitively identify the FATCA status of its individual or entity account holder has what’s called a recalcitrant account holder on its hands. If the account holder is another financial institution, the default status is ‘non-participating FFI’ (or ‘NP-FFI’ for short). Now, from the US perspective, the world falls into three categories – IGA Model 1, IGA Model 2 and Non-IGA jurisdictions. In the non-IGA markets, the raw US HIRE Act applies directly (and extraterritorially) in which recalcitrant account holders must be penalised in FATCA and reported and, unless their status is cured, the FFI will have to close the account down in due course. However, in both the IGA Models, the US has provided for a suspension of the FATCA penalty on recalcitrant account holders BUT – and here’s the rub – that suspension is contingent on those recalcitrant account holders still being reported in FATCA.

All this is to say that some firms have compartmentalised compliance efforts and handle each framework separately. Some firms have aggregated the tax evasion frameworks into one compliance model leaving income taxation handled separately. This latter compartmentalisation creates problems.

Continuing my second example, we are seeing, via the review process, that some firms have failed to properly obtain the FATCA status of their clients. While this is usually in cure process, it technically leaves those accounts as reportable in FATCA  because they are recalcitrant until cured. And, if they had been reported, then the IGA suspension of FATCA penalty would have effect. However, in the reviews we have seen there is often a disconnect caused by this operational and knowledge compartmentalisation. What happens is a misunderstanding or misreading of the IGA and/or its local equivalent in domestic law. Several of the firms we reviewed had recalcitrant account holders, had not included them in their FATCA report, had not applied any FATCA penalty (thinking there was none to apply) and then taxed the income in Chapter 3 and even given treaty benefits to some account holders. In reality, the recalcitrant account holders should have been included in the FATCA report and it would have been that inclusion, and only that inclusion, that triggered the suspension of the FATCA penalty. The fact that they did not include recalcitrant accounts in their FATCA report meant that the suspension of FATCA penalties could not be applied and a FATCA 30% penalty should have been withheld, thus meaning that no Chapter 3 tax was applicable and certainly no treaty benefits. In the cases in point, tax was withheld at the wrong rate (under-withholding) and categorised incorrectly on information reports and tax returns. The FATCA reports would also have been both inaccurate and incomplete. In other words, a seemingly small misunderstanding of one clause in an IGA creates multiple inaccuracies in withholding, categorisation of tax and reporting. This in turn leads to an easy inference that the firms involved clearly don’t have effective controls in place, that in turn leads to a Responsible Officer having to make a qualified certification to the IRS in which they are admitting to compliance failures to the US regulator. In the case of FATCA failures like these, depending on the scale and scope of the issue, it is possible the US would not consider these to be ‘minor administrative’ issues but material, in which the US Competent Authority would engage the local Competent Authority/regulator to take local corrective action with its domestic financial institution. I should point out here that, even though there is no requirement in FATCA for a Responsible Officer, the overlap of the QI regulations means that any QI has to have a Responsible Officer and the QI Agreement includes compliance to FATCA. So, again, the overlap – if not understood and applied correctly or effectively – can create serious unintended consequences.

If you’d like to know more or have a conversation about our services, including training, guidance, Interim Compliance Reviews (ICRs) and Remote Interim Compliance Reviews (R-ICRs), please get in touch.

Photo by Austin Neill