Basic Facts on FATCA and Maritime Contracts
April 2012A controversial new US withholding tax known as FACTA (the Foreign Account Tax Compliance Act) is of interest both because it may be a potential trap for those engaged in international maritime transactions and also because it may result in agreements among countries to share data about their citizens’ foreign accounts.
FATCA may result in the imposition of a 30% withholding tax under some maritime contracts. The gross-up provisions commonly used in contracts today would make the wrong party liable (the one with no control over whether the tax was incurred). To the extent the law induces international data sharing agreements, the tax will become irrelevant because all the financial institutions in a signatory country will be deemed qualified or participating by submitting data to their own governments that will be shared with the governments of other countries.
A. Background
US citizens are subject to income tax on their worldwide income including interest, dividends and capital gains earned in foreign accounts. Taxpayers are required to report to the IRS all foreign bank and investment accounts they own that are in excess of $10,000. Unlike domestic banks and brokerage firms, foreign financial institutions (“FFI’s”) are not required to report the earnings of US depositors and investors to the IRS. Consequently, many US taxpayers have been unable to resist the temptation to hide the existence of their foreign accounts from the IRS in order to obtain tax-free compounding of their investments. The bank secrecy laws of some countries have further encouraged this type of tax evasion, although it has been diminished by the recent cooperation of Swiss banks with the IRS.
Any tax system that relies on voluntary compliance (as the US does) would be ineffective without a reporting system for revenues that is independent of the taxpayer. Financial institutions in the US currently report annually to the IRS the amount of interest and dividends earned by depositors, but there is no reporting system for many US holders of accounts in other countries. FATCA is intended to cover this gap in reporting.
This gap is closed by imposing the 30% withholding tax, essentially a nuisance tax, on certain payments made by US persons to an FFI irrespective of whether the FFI is the beneficiary of the payment or an intermediary. The tax can be avoided if the FFI has entered an agreement with the IRS to provide information periodically on US account holders (after following specified procedures to identify them).
The tax is unusual because it is not directed at the real target of the IRS, the US depositors of a non-participating FFI, but at a commercial party that might not otherwise be subject to taxation in the US. This result is accomplished through the legal fiction of declaring the US payor to be a withholding agent, and requiring it to withhold 30% of the payment owed to its counterparty and send it to the IRS. Assuming that the counterparty is the beneficial owner of the payment (and is not a non-participating FFI), it will be able to apply the withheld amount to any US tax liability it may have and obtain a refund for the balance. Procedures for obtaining refunds will be established in future regulations. Refunds will not be made to non-participating FFI’s unless they disclose information about US account holders (except that existing treaty provisions would apply).
The effect of the act is to discourage parties from using FFI’s to which the tax would apply. In fact, avoiding non-participating FFI’s is the best defensive action that can be taken. In most cases, it would also be appropriate to exclude FATCA liability from any contractual gross-up provisions and to specify in the contract that a party selecting an FFI shall bear any related FATCA liability.
A more efficient way to deal with the problem and one that would be less of a burden on commerce, would be to have FFI’s report data on all of their accounts to their own tax authorities. Most developed country governments require, like the US, reporting on domestic holders of accounts. Then, instead of individual agreements with the IRS, the requirement that FFI’s also report on non-domestic accounts would be contained in the local law and the governments involved would exchange information on their respective citizens. The IRS is reportedly in discussions with several governments in an effort to implement this approach. FFI’s in countries that become parties to such governmental agreements will be deemed “participating” under FATCA.
It will be interesting to see how many FFI’s and/or governments refuse to agree to make reports at the cost and inconvenience of the 30% withholding and likely diminished participation in international trade. Countries that decline to enter agreements will also lose the reciprocal benefit of receiving data on their citizen’s foreign accounts.
B. The Law and Regulations
The basic provisions of FATCA were adopted in 2010 and are contained in Sections 1471 through 1474 to Title 26 of the U.S. Code. Details as to compliance are to be provided by regulations. Proposed regulations were published in February 2012. These are subject to public comment and possible revision. The comment period closes at the end of April 2012, a public hearing is scheduled for May 15, 2012, and final regulations are likely to be published several months later.
Whether FACTA will become a major concern for the international maritime trade depends on whether most FFI’s in the industry enter into the required agreements with the IRS or otherwise qualify (known as “participating FFI’s”) or their governments enter into data exchange agreements with the US. Even if most FFI’s participate, there will undoubtedly be some that do not, and the consequence of a party’s unwittingly failing to withhold on a payment to a non-participating FFI is personal liability for the tax.
C. Applicability
The tax applies to “withholdable payments” by a “US person” to a non-participating FFI. “Withholdable payments” are: (i) fixed periodic payments, including interest, dividends, rent, salaries and any kind of compensation from sources within the United States; and (ii) the gross proceeds of certain financial assets of a type that can produce interest or dividends from sources within the United States (such as stock). A “US person” is any US taxpayer except publicly-traded corporations and their affiliates, governmental entities, tax exempt entities, banks and certain types of investment companies.
The proposed regulations contain a “grandfather” provision exempting payments pursuant to agreements in existence on January 1, 2013 from the tax. Any such contract that is substantially modified after the cut-off date will not be exempt.
Under the proposed regulations, payments made in the ordinary course of business for non-financial services, goods and the use of property would be exempt from the tax. They provide that “interest on outstanding accounts payable arising from the acquisition of nonfinancial services [and] goods…” is also exempt. “Accounts payable” includes only current liabilities which are generally those becoming due within one year, and does not include long term debt. The regulations provide that the exemption does not apply to interest other than that described in the text quoted above.
Withholding would not apply to charter hire payments and payments under other types of service contracts, but there are several instances in the maritime industry in which the tax would be applicable. It applies to: (i) payment of interest (other than on accounts payable) by a “US Person” to an FFI; (ii) payment of dividends by a “US Person” to an FFI; (iii) payment of salaries to an FFI; and (iv) the gross proceeds of the sale of stock in a domestic corporation (and any foreign corporation whose interest and dividends would be from US sources). (The tax also applies to payments to certain non-financial foreign entities or “NFFE’s,” that do not provide the IRS with information as to US ownership, but such payments would not likely arise from a maritime contract.)
After January 1, 2013, a privately held US shipowner, therefore, should avoid entering into a loan agreement with a foreign lender that is not a participating FFI. For such an owner, consideration should be given to including in the loan documentation provisions limiting syndication, participation and swap providers to participating FFI’s. Because remaining a participating FFI requires on-going obligations, including a provision that before an FFI becomes a non-participating FFI, it will divest its interest to a participating FFI should also be considered.
Dividends payable by a privately held US shipowner to an FFI are subject to FATCA as are salaries. In both cases, the recipient will want to ensure that the payments are made to a participating FFI.
The proceeds of the sale of stock in a private domestic shipowner (or a foreign shipowner whose source of interest and dividends is the US) will be subject to the tax if they are paid to a non-participating FFI.
D. Participating FFI’s
For a foreign bank to qualify, it must enter into an agreement to make periodic electronic reports to the IRS of the name, address, tax identification number, account balance and account number for each account held by a US person. The IRS has said that it will begin accepting applications by banks to enter into agreements not later than January 1, 2013. Where a foreign bank is unable to report the required information with respect to an account with “US indicia” because, for example, the account holder refuses to waive applicable reporting restrictions, the bank must report such accounts to the IRS as recalcitrant account holders.
As mentioned above, an alternative arrangement is being explored under which the US would obtain agreements with other governments for a reciprocal data exchange. Under this arrangement, the foreign bank would make the reports to its own government. The US would presumably also agree to provide data to the other governments on accounts in the US held by its citizens. This approach could simplify the FATCA procedures because one would have to examine the status of an FFI only if it is based in a country that is not a party to a data exchange agreement.
Foreign banks that refuse to accept accounts for US persons or for US owned foreign entities and have satisfactory procedures in place to prevent the opening of such accounts will be deemed to be participating FFI’s, provided that they report their procedures to the IRS every three years. If a data exchange agreement is obtained, this arrangement would presumably be included in it.
Participating FFI’s will be listed by the IRS so that parties know at the time of payment whether withholding is required. In addition, forms W-8BEN and W-9 (which are being modified by the IRS) will be considered acceptable certifications that withholding is not required.
The agreement between a participating FFI and the IRS will include an agreement by the FFI to withhold 30% of any “passthru payment” to a recalcitrant account holder or to a non-participating FFI. A “passthru payment” is any withholdable payment or other payment to the extent attributable to a withholdable payment. To comply with this term, the FFI will need to know the nature of the payment received as well as the status of the downstream FFI. A participating FFI may elect instead to be subject to withholding on payments it receives when the payments are allocable to recalcitrant account holders or non-participating FFI’s. Thus, there are two categories of participating FFI’s – those that are fully participating and not subject to any withholding, and those that are partially participating and subject to withholding on passthru payments. The IRS has acknowledged the difficulty that FFI’s may have in complying with the passthru requirements and has said that withholding on them will not be required before January 1, 2017. In the meantime, the proposed regulations require participating FFI’s to report the annual aggregate amount paid to non-participating FFI’s.