U.S. Financial Institutions and FATCA

Little is written regarding FATCA and U.S. Financial Institutions (FI).  That said, U.S. Financial Institutions have FATCA responsibilities.  In the absence of permitted exceptions, FATCA requires U.S. FIs that make payments of most types of U.S. source withholdable income to non-U.S. persons to withhold a 30% tax on that income.  This requires U.S. Financial Institutions to maintain certain documentation regarding those non-U.S. persons and to track how those persons are classified under FATCA. 

Although FATCA is more burdensome for Foreign Financial Institutions, U.S. Banks must develop their own “best practices” for ensuring U.S. side compliance.  It is imperative for U.S. Banks to have procedures in place for properly classifying outbound payments and their source of the related income. U.S. Bank Accounts Payable Departments happen to be where most of these payments are issued. U.S. Banks ought to have a process in place to ensure proper withholding direction, and a process for easy access to the right department (whether compliance, legal or tax) for analysis and resolution if needed.  

There are three steps for U.S. Banks to determine the status of the payee (person to whom money is paid)

1. Is it a US citizen, Permanent Resident or a Foreign Person?  A Foreign Person would be a Non-Resident Alien (NRA), a Foreign Corporation, Foreign Partnership or Foreign Trust. 
2. Look at related payee documentation.  What are we looking for?  Withholding Certificates (W-8 series) that are completed and accurate.  The Withholding Certificates are critical for determining the documentation status of the payee.    Proceeding with a client if a Bank does not have valid and properly executed paperwork leaves it vulnerable to IRS sanctions. 
3. The third step applies to the Foreign Person payee.  In the case of foreign payee persons, uncertainty for the US Banks starts when they are trying to distinguish between FDAP (Fixed, Determinable Annual and Periodical Income) and ECI (Effectively Connected Income).  The identification of type of income (ECI versus FDAP) determines the withholding responsibility of the Bank. The good news is that if you are an NRA, the IRS only wants to collect tax on the money earned in the US.  

Understanding FDAP and ECI

The terms FDAP and ECI are expansive terms.  ECI is income that is effectively connected with a US trade or business activity.  When income is “effectively connected” with a US trade or business, the income is taxed at graduated rates, just like a US person.  So, if you have a job in the US, or if you run your own business, then that income is recognized as “effectively connected” to a US trade or business.  Examples are maintaining a fixed office with employees, storing goods for sale to US buyers, soliciting orders through a dependent agent, providing logistics support for an export business, or management of a U.S. real estate business. 

FDAP, on the other hand, is meant to capture everything not ECI.  FDAP income (must be US sourced) is generally known as:  passive investment income, such as interest or dividends.  However, it can also include other sorts of income, such as:  compensation for personal services, rent, royalties, pensions, annuities, alimony, and social security.  FDAP income is taxed at a flat 30 percent rate on a gross basis.  A lower treaty rate may possibly apply.

Enforcement of reporting and tax withholding obligations is a focus of IRS collection efforts

Numbers of the individuals that are responsible for ensuring compliance with the rules applicable to the US Financial Institutions may not be sufficiently familiar with the rules or are not aware of the consequences for lack of compliance.    A U.S. Bank is required to withhold 30% of FDAP payments to NRAs absent proper withholding certificates – the W-8 series.   The U.S. Bank is responsible for remitting the withheld taxes to the IRS.   Besides withholding, (if necessary), and remitting to the IRS, the US Bank also has to report FDAP payments to NRAs by filing Form 1042 and related Forms 1042-S.  U.S. Financial Institutions must ensure that they have the right Accounts Payable processes in place. 

Consult your FATCA specialist now.