This blog is for the purists out there. Those who like to take the high ground and find solace in tracing the minutiae of regulations through to their operational conclusion. It’s a great game because the regulations are pretty complex, but the route to an operational conclusion is fraught with commercial policy which is too often driven by simple lack of attention to detail and a lack of customer focused ethic. The problem is that, like the Death Star in Star Wars, both Chapter 3 and Chapter 4 regulations are cascade in nature and have structural weaknesses that are not immediately apparent until you follow through.

The main problem is that if the firm at the top of the chain gets it wrong, everyone else in the chain below them has an incentive to replicate or compound the error. If they try to correct an upstream error, all that happens is that the IRS issues a penalty notice – to the downstream entity. As long as the numbers on the 1042 match the aggregate1042-Ss all is well – even if they’re wrong because the system does not have a robust enough set of checks and balances through the chain. The Force may be strong in this one, but it’s the dark side that’s awakening. Let me walk you through a real example.

The Scenario

A US withholding agent has a client who is an NQI in Chapter 3 and who, part way through the 2015 tax year established their Chapter 4 status and provided the USWA with a new W-8IMY on which they presented their GIIN and asserted that they were a reporting Model 1 FFI. Nothing wrong with that. Quite a simple and fairly common scenario.

The Response

The USWA rejects the W-8IMY and, as a result, essentially acts as if it never got the GIIN. It writes to its customer and informs them they are ‘recalcitrant’ and despite many attempts to cure the IMY rejection, they are penalised on US Sourced FDAP payments with a FATCA 30% penalty for the whole year. They tell their client to have their underlying customers file a tax reclaim.

The client is understandably upset but can’t get any remediation from their USWA apparently on the grounds that ‘this is how the regulations work’, ‘ the FATCA withholding isn’t a penalty’ and ‘we can’t give tax advice’. Now the client has to figure out what to say to its customers who are 30% down.

A Catch 22 Situation

So, lets break this down a bit. There’s a catch 22 in this story. The chances are that the USWA classifies all non compliant clients as ‘recalcitrant’. Its an understandably simplistic, albeit incomplete nomenclature. This probably originated as a systems issue with someone not realising (or being properly briefed) that there are two categories of non compliance not one, and worse, the tax treatment of each is substantially different. The term ‘recalcitrant’ is reserved for individuals and NFFEs in IGA markets. FATCA penalties on recalcitrant account holders are generally removed as part of the intergovernmental deal. The other type of non compliance is ‘non participating’ and is reserved for FFIs. So, if they really think their client is recalcitrant, why are they applying a FATCA penalty? If they know that their client is actually an FFI, why aren’t they referring to them as non participating? Inaccurate use of regulatory terminology is not arcane – it affects credibility in the market.

Light vs Dark

So, let’s put the loose use of terminology aside for a moment. This USWA clearly has both ‘reason to know’ and ‘actual knowledge’ that its client is an intermediary. It does not need a W-8IMY to make that determination. You’d think at this stage that having clients with needs would bring out the service ethic or ‘Light Side of the Force’ in most firms but apparently not. It brings out the Dark Side. The regulations provide the USWA with a grace period of 18 months during which, even without a GIIN, they can treat their client as a participating FFI and not apply any FATCA penalty. So, again, they did not need to financially penalise their client. But they did not avail themselves of this simple rule, they stuck to a 30% penalty and told their client to have their underlying customers, the beneficial owners, go file a tax reclaim to the IRS.

Now, at this stage in the story, we must remember that the further down the financial chain you go, the lower the available resources, knowledge and experience, which means that downstream clients have a reduced capacity and commercial clout to challenge their upstream counterparty’s positions. The fact that the top of the chain is both getting it wrong and misinforming its clients only makes the downstream situation much more difficult to resolve. Even informing clients of the firm’s policy, at this stage, doesn’t mean it is right either technically or ethically and believe me, this industry has reason to pay attention to ethics. There needs to be a combination of accurate interpretation of the regulations, good and consistent education and full disclosure of which parts of a policy are based truly on regulation and which are based on commercial policy.

Is a Reclaim Really the Answer?

Let’s now handle the tax reclaim piece of this story. I read an interesting report a week or so ago from one of the Big Four that indicates that the IRS is starting to reject long form tax reclaims. Their problem, apparently, is that, while the beneficial owner may have a 1042-S reporting that tax was over-withheld, the IRS wants evidence that the reportedly over-withheld tax was actually physically paid. Well, if you know anything about the industry, the chain of intermediation and the way US tax is typically paid to the US Treasury, you’ll know that this requirement is effectively impossible to meet. So the assertion that a claim is the solution may be technically correct but is highly misleading because the chain of intermediation itself creates the barrier to its success. What’s strange here is that the USWA does not realise the risk associated with that position. In this case, the withholding was a FATCA penalty and any claim made would be (i) for the whole amount and (ii) accompanied by evidence that the penalty was applied in error (see all the arguments above). I can only imagine who the IRS would be likely to call if it got two or three thousand claims for erroneous FATCA penalties all related to one USWA – reputational risk.

The problem of the claim scenario is further complicated because of a concept called ‘non duplicative taxation’. The rule for any payment of US sourced FDAP income is ‘apply Chapter 4 rules first, then Chapter 3. In this case study, the USWA has applied Chapter 4 and withheld a 30% penalty. Since for most purposes that’s the maximum that can be withheld, it now applies Chapter 3 rules and, because of the non duplicative taxation principle, now withholds nothing at all in Chapter 3. This gives the IRS and everyone else a problem. If the IRS accepted and paid the claims, the USWA would then have to go back down the chain to claim Chapter 3 withholding which it did not apply the first time round. Depending on the timing of these events, this would also trigger an enormous amended reporting cycle. So for these and other reasons, in this case, asking beneficial owners to file claims in any volume could easily backfire.

Awakening The Force

The fact is that there was ample room in this scenario for the USWA to educate its client, help them understand the regulatory context and the reasoning behind some of their commercial choices, tax the income in Chapter 3 and not apply a penalty in Chapter 4 while working with their (presumably valued) client to minimise impact rather than exacerbate it.

As for the Force Awakens? Well, it’s awake, that’s for sure. It would just be a bit better if there was more light than dark.