The Foreign Account Tax Compliance Act (FATCA) has transformed the global tax framework and added a new dimension to the KYC systems.
On March 18, 2010, FATCA was signed into law as a part of the Hiring Incentives to Restore Employment Act (HIRE) with the basic purpose to improve tax compliance for financial assets held by U.S. persons outside the United States.
Under FATCA, all financial institutions, U.S. domestic and foreign, must classify account holders as either U.S. or non-U.S. based. The act will also require foreign financial institutions (FFIs) to report directly to the United States Internal Revenue Service (IRS) specific information about financial accounts held by U.S. taxpayers or by foreign entities in which U.S. taxpayers hold a substantial ownership interest. As part of the compliance process, FFIs are required to enter into a special agreement with the IRS. As per this agreement, FFI needs to:
- Perform identification and remediation procedures to screen the account holders.
- Report annually to the IRS on U.S. account holders or foreign entities with substantial U.S. ownership.
Although FATCA is primarily related to the integration of global tax systems but due the inter-dependency of identification requirements with KYC processes, it has laid down some major challenges and requirements, directly or indirectly, on the KYC systems. These key requirements are grouped under the below four broad categories:
U.S. Person Indicia
Through the introduction of U.S. person indicia, FATCA requires more in-depth customer analysis and documentation. These indicia follow a negative presumption rule that considers all the account holders to be U.S. persons unless proven otherwise. Even after getting proved, the customer profiles needs further scrutiny which requires additional documentation that goes much beyond the scope of KYC procedures.
The indicia of U.S. status:
- U.S. citizenship or lawful permanent resident (green card) status;
- A U.S. birthplace;
- A U.S. residence address or a U.S. correspondence address (including a U.S. P.O. box);
- Standing instructions to transfer funds to an account maintained in the United States, or directions regularly received from a U.S. address;
- An “in care of” address or a “hold mail” address that is the sole address with respect to the client;
- A power of attorney or signatory authority granted to a person with a U.S. address.
These indicia are to be fulfilled for all the accounts without considering the risk based approach. The major challenge is that current KYC systems follow an account-centric approach in which the information is spread across disparate processes and silos based on the account types. As extensive screening is required for customer identification on various levels, such approach will cause multiple information requests for a single customer which may lead to a highly time consuming and costly practice.
As the US person indicia are entirely new requirements in the field of KYC, a new procedure has to be defined which ensure its implementation. Once this threshold meets, the below set of additional documents should be collected and analyzed under the preliminary stage of the remediation process where the analyst screens and attaches evidences/documents:
Enhanced Ownership Criteria
The fundamental KYC-AML regulations generally limit the identification requirement at a 25% threshold of controlling ownership whereas FATCA goes much deeper into the definition of substantial US owner by setting this controlling threshold to 10% for every account. FATCA requires further scrutiny to prove that the 10% owner meets the US person’s indicia.
Not only the institutions need to work within these new boundaries but all the collected information should also be available any time for tax validation analysis.
Legal entities are classified among two major categories Under FATCA:
Foreign Financial Institutions (FFIs)
The definition of an FFI is very broad and is expected to encompass a number of entities generally not considered to be financial institutions. An FFI is any foreign entity that:
- Accepts deposits in the ordinary course of a banking or similar business;
- As a substantial portion of its business holds financial assets for the account of others;
- Is engaged (or holding itself out as being engaged) primarily in the business of investing, reinvesting, or trading in securities, partnership interests, commodities, or any interest (including a futures or forward contract or option) in such securities, partnership interests, or commodities.
Below are the different FFI classifications that signify compliance with FATCA:
- Participating FFIs (PFFIs): An FFI that enters into an FFI agreement with the IRS is referred to as a “Participating Foreign Financial Institution” (PFFI). An FFI that does not enter into an agreement with the IRS is referred to as a “Non-Participating Foreign Financial Institution” (NPFFI), and is subject to withholding under FATCA.
- Deemed Compliant FFIs: an FFI that meets the procedural requirements described in the regulations is referred to as a “Deemed Compliant FFI”.
- U.S. Withholding Agent (USWA): Any U.S. individual, corporation, partnership, trust, association, or any other entity; that has the control, receipt, custody, disposal, or payment of any item of income of a foreign person that is subject to withholding comes under the definition of USWA.
- FATCA Exempted FFIs: even though an entity falls under the definition of an FFI, it still be excluded if the entity is an- Excepted non-financial foreign entity: An NFFE that is not subject to FATCA withholding and reporting is known as “Excepted NFFE”; and Excepted inter-affiliate FFI
Non-financial Foreign Entities (NFFEs)
Any entity that does not fall under the definition of an FFI would be considered as a Non-financial Foreign Entity (NFFE).
Under FATCA, a FFI needs to:
- Maintain verification and due diligence procedures to identify U.S. accounts
- Obtain documentation of each account holder to determine U.S. or non-U.S. status
- Report detailed information regarding U.S. accounts to the IRS on an annual basis
- Provide the IRS with additional information regarding U.S. accounts upon request
- Deduct and withhold 30% tax on certain payments made by non-compliant account holders
- Exit the relationship if you cannot get a waiver of local secrecy laws
In case of NFFEs, FATCA requires punitive 30% withholding on payments to NFFEs that fail to either: disclose substantial U.S. owners (the 10% threshold owner) or certify that no substantial U.S. owners exist
Apart from the above categories, FATCA further requires a continuous monitoring system to identify any change in the existing information. Unlike the existing KYC processes where periodic monitoring is done based on the risk model followed, these requirements are applicable to all the customers without considering their risk status.
Even though FATCA is the first regulation of its kind to upgrade the KYC scope, it is just an initial step as the law is prepared to phase in new requirements from time to time.