FATCA Guide for Alternative Investment Fund Managers (Rothstein Kass)

August 2013

KEYWORDS: tax, Foreign Account Tax Compliance Act, FATCA, IRS, United States Congress, foreign financial institutions, banks, offshore funds

Authors:

Rothstein Kass

Organizations:
  • Rothstein Kass

Summary:

The U.S. federal income tax system is based largely on voluntary compliance. U.S. taxpayers are responsible for reporting, and paying tax on, their worldwide income. Information required to be reported to the Internal Revenue Service (“IRS”) by third parties, such as employers and financial institutions, allows the IRS to verify taxpayer compliance. With respect to investment income from U.S. sources, there are information reporting, backup withholding and nonresident withholding rules that apply broadly to financial institutions, including foreign financial institutions, and other payors. As a practical matter, however, these reporting and withholding requirements have been difficult to enforce with respect to foreign financial institutions that do not conduct business in the U.S. In addition, foreign financial institutions may be prohibited from reporting information regarding their accountholders to the IRS without violating local bank secrecy, financial privacy, or related laws. This lack of information reporting, coupled with the protection of foreign bank secrecy laws, is believed to have enabled U.S. taxpayers to engage in tax evasion by using offshore accounts to hide unreported income. Based on estimates that the U.S. government was losing in excess of $100 billion annually to U.S. tax evasion, Congress determined that a “big stick” in the form of new legislation was needed to compel foreign financial institutions to report information about their U.S. accountholders to the IRS. Further bolstering the need for such new legislation was the widely-publicized prosecution of a large and well-known Swiss bank for facilitating U.S. tax evasion.

FATCA’s onerous withholding tax regime is the “big stick” created by Congress to force foreign financial institutions to report information regarding their U.S. accountholders for purposes of detecting and deterring tax evasion. Under FACTA, any entity considered to be a “foreign financial institution” (“FFI”) has a choice – they can either agree to identify and report U.S. accountholders or they will suffer 30 percent U.S. withholding tax on nearly all payments they receive from U.S. sources. If applicable, FATCA withholding would apply to many types of payments that are otherwise not normally subject to U.S. withholding tax such as interest income derived from portfolio investments and gross proceeds from the sale of U.S. securities.

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