'JanuaryFebruary

2012

Valuing Illiquid Assets

Commercial Property Tax Appeals

FATCA imposes substantial new reporting and withholding

obligations on non-U.S. financial institutions.

KURT G. RADEMACHER AND SAMANTHA R. MOORE

The Foreign Account Tax Com-

pliance Act (FATCA) has beenthe talk of the financial ser-

vices industry since it was

enacted as part of the HiringIncentives to Restore Employment(HIRE) Act on March 18,2010. FATCAimposes substantial new reporting andwithholding obligations on non- U.S.

financial institutions (including banksand trust companies). Initially, much ofthe industry chatter surrounding FATCAinvolved threats from non- U.S. finan-

cial institutions to close their doors toU.S. clients. However, once the scope ofFATCA became clearer, non- U.S. finan-cial institutions realized that even thisdrastic step would not extricate themfrom FATCA's draconian reporting and

withholding regime because the report-

KURT G. RADEMACHER, an attorney with Butler Snow, isa member o/the Business Services Group where he focuses onprivate client wealth management, estate and trust planning,and international taxation. Mr. Rademacher is recognized by

Chambers USA as a leader in the field o/Wealth Managementlor the Central Region o/the USA.SAMANTHA R. MOORE, an attorney with Butler Snow, is amember 0/ the Business Services Group where she focuses onestate planning and administration and international taxa-tion. Ms. Moore is also a Certified Public Accountant.

18 CORPORATE FINANCE REVIEW JANUARY/FEBRUARY 2012

ing/withholding obligations apply toinvestments in U.S. securities made onbe.half of clients-irrespective of whetherthose clients are U.S. persons.

Practically, FATCA only offers non-U.S. financial institutions two choices:(l) implement costly U.S. style report-ing and account due diligence on behalfof a foreign revenue agency or (2) ceaseoffering U.S. securities to clients. Howmany non- U.S. financial institutions wilchoose the latter option remains to be seen.Though many in the U.S. governmentprobably failed to fully appreciate theissue, Congress and the White House infact gambled with the U.S. financial mar-kets in enacting FATCA.

The U.S. government's gamble was thatU.S. financial markets comprise such anintegral component of the portfolios ofnon- U.S. investors that such investors

would choose not to do business with afinancial institution that was unable tooffer such securities-or at least unable

to offer them without imposition of a 30percent withholding tax. If the bet turnsout to be a winner, the IRS wil obtainsubstantially more information from

non-U.S. financial institutions on U.S.

tax dodgers without pushing alreadyfragile u.s. financial markets into anothertailspin. If the bet turns out to be a loser,non - U.S. financial institutions wil dumptheir u.s.' investment platforms, non-U.S. investors wil flee the U.S. financialmarkets in droves (taking billions of dol-lars in shareholder value with them),and the IRS wil have little more infor-mation than it already possesses aboutU.S. tax dodgers.

Time wil tell whether the U.S. gov-ernment's grand wager pays off. If it doesnot, ordinary Americans wil see theirinvestment/retirement plan balances

plummet through no fault of their own,and the already fragile U.S. recovery

could be impacted.

FATCA legislationFATCA classifies non-U.S. entities aseither foreign financial institutions (FFIs)

or non-financial foreign entities (NFFEs).FFIs and NFFEs are each subject to theirown set of reporting obligations and duediligence requirements in relation to theaccounts that they maintain; this articlefocuses on FATCA's impact on FFIs. Thestated goal of these due diligence andreporting requirements is to root outU.S. beneficial ownership of accounts/entities that have not been reported tothe IRS. Obviously, the IRS does not havethe manpower to physically audit eachand every non- U.S. financial institution

or entity to investigate U.S. connections.Under FATCA, this obligation rests withFFIs themselves instead of with the IRS,

thus accomplishing the unprecedented stepof turning non- U.S. financial institu-tions into a de facto enforcement mech-anism for a foreign tax authority-the IRS.

One might reasonably ask why anyfinancial institution in its right mindwould agree to take on the audit func-tion for a foreign tax authority. Theanswer is that FFIs that fail to comply withFATCA's reporting/withholding obliga-

tions wil incur a 30 percent withhold-

ing tax collected at source on anydividends, interest, or sales proceedsgenerated from U.S. securities.1

FOREIGN FINANCIAL INSTIUTIONS

Taking a simple example, if a Londonbank that does not enter into an FFIAgreement with the IRS invests $50 ofits U.K. resident client's funds in IBMstock, that investment grows in value to$100, and the bank then sells the IBM stockfor $ 1 00 at the client's direction, the salesproceeds wil be subject to a 30 percentwithholding tax. The client wil thereforeonly receive $70 from the sale. The dra-conian nature of this result becomes onlymore evident when one considers that ifthe U. K. resident client had investeddirectly in the IBM stock and had real-ized the $50 gain personally, no portionof that gain would have been taxable inthe U.S., since gains on sales of U.S.stocks are not U.S.-sourced income solong as the seller is not a U.S. citizen orresident.

Under FATCA, a $50 gain that wouldhave been tax-free if realized directlybecomes subject to $30 of tax (a 60 per-cent effective U.S. federal tax rate) whenrealized through a non-participatingFFI. When faced with such dire U.S. fed-eral income tax consequences, clientswho wish to maintain some U.S. equityexposure in a single portfolio wil haveno economic alternative to investingwith a qualified FFI.

FATCA guidance

In addition to the FATCA legislationitself, the IRS has issued three notÌcesexplaining how the provision wil applyto non- U.S. financial institutions.

Notice 2010-60. The HIRE Act grantsthe U.S. Treasury Department author-ity to exempt certain entities from report-ing/withholding as FFIs. Notice 2010-60describes the U.S. Treasury Department'sintention to issue regulations exempt-ing the following entities, among oth-ers, from FFI treatment:

Traditional holding companies thathold interests in operating compa-nies that are not themselves engagedin the financial services industry(but not including private equityfunds, venture capital funds, orleveraged buyout funds);

. Non-U.S. start-up companiesinvesting capital for the purpose of

JANUARY/FEBRUARY 2012 CORPORATE FINANCE REVIEW

THE STATEDGOAL OF THESEDUE DILIGENCEAND REPORTINGREQUIREMENTSIS TO ROOT OUTU.s. BENEFICIALOWNERSHIP OFACCOUNTSIENTITIES THATHAVE NOTBEEN REPORTEDTO THE IRS.

19

CONTROLLEDFOREIGN

CORPORATIONSWERE NOTEXEMPTEDFROM THE

FFI TREATMENT.

20

establishing a business other than afinancial institution for a period of24 months after organization (butnot including a venture fund orother start-up fund that invests innon- U.S. entities);

. Certain non-financial institutionsthat are in the process of reorganiz-ing or emerging from bankruptcy;

. An entity primarily engaged in

hedging transactions for membersof its affiiated group, so long as themembers of the affiliated group arenot primarily financial institutions;

. Insurance companies that issuepolicies without cash value, suchas property and casualty insuranceand term life insurance (treatmentof cash value life insurance andannuity product issuers was notprovided);

. "Small family trusts" settled by asingle person for the sole benefit ofhis or her children (treatment ofmore complex trust structures wasnot provided);

. Investment entities that obtaininformation about their owners andreport to the IRS (under guidanceto be issued) any owner who is aU.S. person; and

. Certain non- U.S. retirement plans

that qualify as such under local law,are sponsored by non- U.S. employ-ers, and only allow U.S. persons whoare employees to contribute.Controlled foreign corporations were

not exempted from the FFI treatment,despite the fact that they are already sub-ject to substantial information reporting.

Notice 2010-60 also specifies the duediligence requirements that FFIs mustapply in determining which new or pre-existing bank accounts it must report tothe IRS. The rules differ for pre-exist-ing individual accounts, pre-existing

entity accounts, new individual accounts,and new entity accounts.

For certain pre-existing individualaccounts, FFIs are required to identify, fromelectronically searchable data, any "indi-cia of potential U.S. status" including:. Whether an account holder has been

identified as a U.S. person;

CORPORATE FINANCE REVIEW JANUARY/FEBRUARY 2012

. Whether the account holder has aU.S. address;

. Whether the account holder's placeof birth is in the U. S.;

. Whether the account lists an "incare of" address or P.O. box as itssole address;Whether a power of attorney or sig-nature authority is granted to a per-son with a U.S. address; and

. Whether the account is subject tostanding directions to transferfunds to an account in the U.S.For new entity accounts, the FFI is

required to determine whether they areU.S. accounts from all available infor-mation-even if such information is notelectronically searchable.

Notice 2010-60 also describes theinformation that FFIs must report inrelation to U.S. accounts and noted thatFFIs wil be required to provide account-related information to the IRS uponrequest (including copies of accountstatements).

The notice requested comments (butdid not provide guidance) on whether non-U.S. collective investment schemes thatprohibit U.S. investors should be exceptedfrom reporting/withholding.

Notice 2011-34. On April 8,2011, the

IRS issued Notice 2011 -34. Notice 2011-34 expands on Notice 2010-60 by sin-gling out the private banking industry forspecial scrutiny and placing significantreporting responsibilities on privatebanking relationship managers (RMs)for all pre-existing accounts that do notmeet a limited de minimis threshold.

A non-U.S. bank or trust companythat chooses to participate in the FFI

program to avoid withholding tax lia-bilities on U.S. securities must ensurethat its private banking RMs screen allexisting private banking accounts forany U.S. indicia. The screening processincludes: (1) identifying those clientswhom the RM has actual knowledge areU.S. persons and (2) performing a "dili-gent review of the paper and electronicaccount files and other records for eachclient" of the RM to 'identify "each client(including any assobated family mem-bers) who, to the best of the knowledgeof the private banking relationship man-

FOREIGN FINANCIAL INSTITUTIONS

ager, has" any indicia of U.S. person sta-tus.

u.s. indicia for these purposes include:. U.s. citizenship or green card for

the account holder;. U. S. birthplace for the account

holder;. U.s. residence or mailing address

(including a U.s. post office box)for the account;

. Standing instructions to transfer

funds to an account maintained inthe u.s. or directions regularlyreceived from a u.s. address;

. An "in care of" address or a "hold

mail" address that is the soleaddress with respect to the client; or

. A power of attorney or other signa-tory authority granted to a personwith a u.s. address.

If the RM identifies an account with anyu.s. indicia, he or she must undertake asecond level of due diligence to estab-lish whether the account in question is aU.S. account. Procedures required toestablish u.s. account status vary basedupon the u.s. indicia present, but generallythe RM must obtain from the client an IRSForm W -9 (if the client is a U.S. person)or an IRS Form W -SBEN (if the client isnot a U.S. person). In addition to IRS

Form W-SBEN, the RM must obtain doc-umentary evidence of non- U.S. status(such as a copy of a non- U.S. passport)for a non- U.S. person. If a client who wasborn in the u.s. provides the RM with IRSForm W-SBEN, the RM must also obtaina written explanation from the clientdescribing the client's renunciation orother loss of U.S. citizenship. The RMmust complete these procedures by the endof the first year in which an FFI agree-ment is in place between the private bankor trust company and the IRS.

Notice 2011-34 places a tremendousadministrative burden on the shouldersof RMs at private banks and trust com-panies. First, an RM must review his orher client list to consider whether he orshe has actual knowledge of any U.S.

persons. The RM must then perform a "dili-gent review" of "paper and electronicaccount files and other records" for eachclient. The process of wading throughclient files and "other records" for any U.S.

FOREIGN FINANCIAL INSTITUTIONS

indicia promises to be a tedious andtime-consuming exercise. Inclusion ofthe phrase "other records" in the noticewould also seem to include recordedtelephone conversations with clients thatmany private banks maintain, meaningthat the notice may force RMs to reviewmany hundreds of hours of recordedtelephone conversations, listening forthe slightest hint of U.S. indicia.

Financial institutions and trust com-panies that sign FFI agreements mustmandate these steps as part of their poli-cies and procedures. RMs wil thereforeface the daunting challenge of main-taining client relationships (and build-ing new ones) on top of the additionaltime required to review voluminousaccount information and "other records"for each existing client.

The notice authorizes outsourcing ofthe review of existing client files for U.S.indicia, though primary responsibility forany errors remains with the financialinstitution or trust company. RMs andthe institutions for which they work mayfind themselves with no practical alter-native to outsourcing, particularly forvoluminous client files where the RMdoes not have any reason to believe thata U.S. connection is present. Affectedinstitutions should take care to ensurethat any such outsourced review occurswithin the scope of a legally privilegedengagement to provide maximum pri-vacy for client information.

Notice 2011-53. On July 14,2011, theIRS issued Notice 2011-53, which pro-vides more time for non-U.S. banks andtrust companies to implement FATCA's

information reporting, withholding, anddocumentation requirements. As originallypublished, Notice 2011-53 applied onlyto FFIs and not NFFEs. This omissionleft many to speculate that the phased-inimplementation would simply not applyto payments made to NFFEs" However,

on July 25, 2011, the IRS revised'the noticeto clarify that the phased-in approachwould apply to NFFEs as well as FFIs.

Notice 2011 -53 provides the follow-

ing timetable/deadlines for FFIs to imple-ment FATCA:

JANUARY/FEBRUARY 2012 CORPORATE FINANCE REVIEW

NOTICE 2011 -34PLACES ATREMENDOUSADMINISTRATIVEBURDEN ON THESHOULDERS OFRMS AT PRIVATEBANKS ANDTRUSTCOMPANIES.

21

THE IRS HASPROVIDED

ADDmONALTIME FOR

FINACIALINSTIONS

TO REAYTHEMSELVES

BEFORE FATCAWITHHOLDING

BEGINS.

FFI Registration Timeline:

No later than January 1, 2013: IRS

wil begin accepting electronic FFI

applications;June 30,2013: Deadline for FFIs toenter into FFI agreements to beidentified as "participating FFIs"that wil not be subject to FFI with-

holding from January 1,2014;

July 1,2013 through December 31,2013: FFIs entering into FFI agree-

ments during this timeframe willbe identified as participating FFIs

for 2014 but may not be identifiedin time to prevent withholdingbeginning January 1,2014.

Due Diligence:. New accounts: FFIs wil be required

to implement account opening pro-cedures aimed at identifying U.S.accounts beginning on the effectivedates of their FFI agreements;

. Pre-existing accounts containing at

least $500,000 and associated witha private banking relationship:Within one year of the effectivedate of the FFI agreement, an FFImust complete pre-existing accountdue diligence procedures describedin IRS Notice 2011-34 for thoseaccounts opened prior to the effec-tive date of the FFI agreement;Pre-existing accounts containingless than $500,000 and associatedwith a private banking relationship:By the later of December 31, 2014 orone year after the effective date ofthe FFI agreement, an FFI mustcomplete the pre-existing accountdue diligence procedures describedin IRS Notice 2011-34 for thoseaccounts opened prior to effectivedates of the FFI agreement;All other pre-existing accounts: AnFFI must complete required due

diligence within two years of theeffective date of the FFI agreement;

. The notice states that additional

guidance will be provided relating tothe scope of private banking duediligence procedures and the associ-ated search of account holder files.

22 CORPORATE FINANCE REVIEW JANUARY/FEBRUARY 2012

Reporting:. June 30,2014: An FFI must obtainIRS Form W -9 from accounts having

U.S. indicia;

. September 30, 2014: An FFI mustreport all accounts for which itobtained IRS Form W -9. Addition-ally, FFIs must report all accountshaving U.S. indicia for which theywere not able to obtain the requiredinformation;

Withholding:. January 1,2014: Withholding on U.S.

sourced FDAP payments begins;. January 1,2015: Withholding on all

withhold able payments to FFIs andNFFEs begins (including U.S.-sourced FDAP payments and grossproceeds from sales of U.S. securi-ties) ;

. No sooner than January 1,2015: FFI

withholding on passthru paymentsto non-participating entities andrecalcitrant account holders begins.

Further Guidance:

. Early 2012: IRS anticipates issuing

proposed regulations;. Summer 2012: IRS anticipates

issuing final regulations, draft FFIagreements, and reporting forms

for use by withholding agents andparticipating FFIs.

What five steps should FFls take now?As outlined above, the IRS has issued asubstantial amount of guidance on imple-mentation of FATCA. In recognition ofthe herculean effort that financial insti-tutions face in complying with this pub-lished guidance, the IRS has providedadditional time for financial institutionsto ready themselves before FATCA with-holding begins. Nevertheless, the sub-stantial lead time necessary to buildproper reporting/due diligence mecha-nisms that interface with current infor-mation technology means that financialinstitutions should take the followingsteps now:1. FFIs should take a hard look at

whether their business modelsrequire them to offer U.S. securitiesto their clients and whether offeringa U.S. investment platform is worth

FOREIGN FINANCIAL INSTITUTIONS

the price of substantial FATCAcompliance costs;

2. FFIs should realize now that thatthey cannot avoid FATCA compli-ance obligations by closing theirdoors to ,U.S. customers;

3. FFls that choose to offer a U.S.

investment platform should enterinto FFI agreements so that theybecome "participating FFIs" beforeJune 30,2013;

4. FFIs should begin investigating andthen integrating tracking/ reportingsoftware into their information tech-nology systems so that u.s. accountscan be monitored and the proper IRS

reports can be generated;

5. FFIs in the private banking arenashould identify a law firm with suf-

FOREIGN FINANCIAL INSTITUTIONS

ficient para-professional supportstaff and experience in reviewingvoluminous documentation to assistin completing due diligence on allpre-existing accounts before the

later of December 31, 2014 or oneyear from the effective dates of theirFFI agreements. A law firm shouldprovide this review (as opposed to anon-legal service provider) so thatif the review uncovers questionableactivities by any RM or otheremployee, this information willremain legally privileged. .

NOTES1Technically, FDAP withholding is broader than inter-

est and dividends, but these are likely to be themost common types of non-sale payments upon whichFATCA requires withholding.

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