It seems as though many of my observations regarding some of the more obvious holes in either FATCA (Chapter 4) and/or the QI regulations (Chapter 3) are finding an interested audience. So here’s another one that occurred recently:

There are two possible ways in which a financial institution outside the US could have its US sourced income taxed at 30%. The first is under FATCA and the second is under the QI regulations. I put them in that order because that’s the order the regulations say a withholding agent or QI should assess/treat any payment of US sourced income to a non-US person.

Phantom Menace?

Well, yes, because its a problem that should not even exist. What do you do if you receive a W-8IMY on which, in Chapter 4, your client says they are a P-FFI (or compliant equivalent) and gives you a GIIN, then in Chapter 3 on the IMY they say they are an NQI and not prepared to disclose their underlying clients? The answer appears, from a couple of US withholding agents at least, to be: ‘We obtain a W-8IMY form from our clients. Any that are NQIs we will tax at 30% FATCA withholding’.

This is a real statement from a real person. What’s wrong with this (if anything)? Well, pretty much everything actually.

In my consulting and training assignments it’s certainly not uncommon to find that financial institutions confuse these two IRC chapters. It’s not helped by the fact that many parts of these two chapters are indeed being converged. However, to act correctly, you have to interpret the regulations correctly, in the right order and in the right context. To a large extent, that means keeping them separated. The real difficulty for the industry is that if these mistakes are made at the top – at a US Withholding agent or a QI – the error (and the consequences of it) can ripple down the chain until it essentially becomes unfixable.

Get your language right

Let’s get back to that rather simple looking statement. The first problem is one of language. It tells me that the author was at best confused (not a good starting point). That’s because the term NQI is a Chapter 3 term, not a Chapter 4 FATCA term. So the phrase ‘FATCA withholding on an NQI’ is a meaningless statement. Since 2014 the validation process for a W-8IMY has been bifurcated. The first step of the validation process is to obtain the presenter’s Chapter 4 FATCA status. In Chapter 4, the language is different and the presenter will (with an IMY) essentially be telling you that they are a Foreign Financial Institution or FFI. For reference and completeness here there are only two other types of FATCA classification at this level: individual and NFFE.

Back to the IMY. There are several types of FFI, and that’s what the form will be telling you. But here’s the important bit: in Chapter 4 there is no such status or classification as ‘NQI’. The determination about whether to withhold under FATCA only occurs based on, and flows from, the Chapter 4 status – not the Chapter 3 status. The circumstances for withholding in FATCA would be (in a W–8IMY scenario) ‘non participating FFI’ or a participating FFI which has elected to be withheld upon (in which they would be disclosing or telling you about underlying FATCA withholding that they want you to do on their behalf). Remember also that ‘disclosure’ in this context refers only to US reportable account holders.

Once you’ve established the presenter’s Chapter 4 status, the second step of the validation of the form is assessing their Chapter 3 status. The purpose of the same W-8IMY form in Chapter 3 is different. It’s to establish the non-US type, form and residency of the presenter and assess any claims to treaty benefits they might be making. Here you can and often do have NQIs as intermediaries and they often refuse to disclose their clients. Remember here that the disclosure referenced is of all non-US account holders. So the term ‘disclosure’ has two very different meanings. As you can see, the language that someone uses can tell you an enormous amount about whether they know what they are talking about in the first place.

Here’s the nub. The refusal to disclose non-US recipients in Chapter 3 has nothing whatsoever to do with the firm’s Chapter 4 status or its compliance and so there is no regulatory reason why a firm that happens to be an NQI in Chapter 3 should be penalised per se with FATCA withholding in Chapter 4. The two issues are just not related.

Expediency vs best interests

Now, as I find in many circumstances, what an upstream institution tells its clients may have more to do with commercial expediency than it has to do with regulation. And so, it’s possible that the person making these statements to its customers is actually making a risk decision rather than a regulatory decision i.e. if you withhold in FATCA, you’ve covered off any risk in this tax evasion regulation hot potato PLUS you now don’t need to do anything at all in Chapter 3 – you just made your job easier as a QI or USWA – but at the expense of your client’s interests and potentially your reputation.

However, in this instance it’s more likely to be a lack of understanding (demonstrated by the misuse of language) that has led to an incorrect policy and subsequent damaging procedure. Downstream institutions, such as NQIs have very little understanding of the regulations and tend to believe what they are told, which unfortunately will only usually exacerbate the situation. This leads ultimately to a client downstream being withheld at 30% in Chapter 4 instead of 30% in Chapter 3. In both cases, the client will want a refund if they are entitled to a lower treaty rate, exception or an exemption. If they were withheld in FATCA, the irony is that they would not have a claim against the IRS – it would be a claim against the withholding institution as refunds are generally subject to the rule in FATCA that these will only be done ‘in case of an error’. Well, there was an error. The problem is that the withholding agent was the one who created the circumstances of the error and is therefore unlikely to see their action as an error.

These are really very complex regulations and it’s easy to get them confused. But NQIs should make sure that they don’t just accept what they are told by their upstream counter parties. Challenge the basis, particularly when ‘regulation’ is cited as the reason. After all, you are the customer.

Image Credit: Sam Valadi