One of the key concepts in FATCA compliance is a “financial institution”. The definition of a financial institution (“FATCA Financial Institution”) is contained in the FATCA Model IGAs. In this article, I will explore some of the general concepts central to defining a FATCA Financial Institution.
Four Types of FATCA Financial Institutions
The concept of FATCA Financial Institution is defined in the Model IGA Agreements. Both Model 1 and Model 2 IGAs agree on the definition of FATCA Financial Institution: “The term ‘Financial Institution’ means a Custodial Institution, a Depository Institution, an Investment Entity, or a Specified Insurance Company.” Let’s go over each concept in more detail.
Definition of a FATCA Financial Institution: Custodial Institution
FATCA Model Agreements provide a fairly straightforward definition of a Custodial Institution: “The term ‘Custodial Institution’ means any entity that holds, as a substantial portion of its business, financial assets for the account of others.” In this context “substantial” means that, during the specified period of time, twenty percent or more of the entity’s gross income is derived from holding of financial assets and related financial services.
The specified period of time is defined in Model 1 IGA as “the shorter of: (i) the three-year period that ends on the December 31 (or the final day of a non-calendar year accounting period) prior to the year in which the determination is being made; or (ii) the period during which the entity has been in existence.”
Definition of a FATCA Financial Institution: Depository Institution
According to FATCA Model IGAs, “The term ‘Depository Institution’ means any Entity that accepts deposits in the ordinary course of a banking or similar business.”
This definition is fairly self-explanatory, but it should be noted that interest-paying client money accounts operated by insurance companies are included within the definition of a depository institution.
Definition of a FATCA Financial Institution: Specified Insurance Company
According to FATCA Model IGAs, “the term ‘Specified Insurance Company’ means any entity that is an insurance company (or the holding company of an insurance company) that issues, or is obligated to make payments with respect to, a Financial Account.” This definition basically applies to all insurance companies that issue or must make payments with respect to an Insurance Cash-Surrender Value Contract or Annuity contract (which is similar to an FBAR).
For the purposes of this essay, I am not going to engage in the discussion of a Financial Account definition (this is an issue that I addressed in another article); suffice it to say that the definition of a Financial Account under FATCA closely follows the FBAR definition of the same concept.
Definition of a FATCA Financial Institution: Investment Entity
Finally, FATCA Model IGAs provide a detailed definition of what constitutes an “Investment Entity”. This concept includes any entity that conducts as a business one or more of the following activities or operations for or on behalf of a customer:
“(1) trading in money market instruments (cheques, bills, certificates of deposit, derivatives, etc.); foreign exchange; exchange, interest rate and index instruments; transferable securities; or commodity futures trading;
(2) individual and collective portfolio management; or
(3) otherwise investing, administering, or managing funds or money on behalf of other persons. This subparagraph 1(j) shall be interpreted in a manner consistent with similar language set forth in the definition of “financial institution” in the Financial Action Task Force Recommendations.”
Notice that this definition encompasses any entity that is managed by an Investment Entity. Further note that the definition of an Investment Entity should be interpreted in a manner consistent with the definition of a “financial institution” in the Financial Action Task Force Recommendations.
Implications if FATCA Financial Institution Definition on Undisclosed Foreign Accounts
The broad definition of a FATCA Financial Institution has a profound impact on US taxpayers with undisclosed foreign accounts. The chief reason for this conclusion is the fact that as soon as an entity is classified as a FATCA Financial Institution, the entity must be FATCA compliant (unless it falls within a FATCA exemption) and should report all of its accounts owned (directly or indirectly) by US taxpayers.
Contact Sherayzen Law Office for Help With Undisclosed Foreign Accounts
The consequences of the IRS discovery of an undisclosed foreign account can be disastrous for the US owner of this account, including extremely high monetary willful civil penalties as well as criminal penalties.
This is why, if you have an undisclosed foreign account, please contact Mr. Eugene Sherayzen, an experienced international tax attorney of Sherayzen Law Office as soon as possible. Our team is well versed in FATCA compliance, FBARs and other foreign reporting issues. We have helped hundreds of US taxpayers around the globe and we can help you.
The Foreign Account Tax Compliance Act (FATCA) created a worldwide international tax compliance regime that has influenced more industries than simply foreign financial institutions. FATCA compliance presents a formidable challenge even to hedge funds.
FATCA Compliance Challenges for Hedge Funds
The challenges that FATCA compliance poses to hedge funds is best understood by analyzing what FATCA compliance requires of hedge funds – a multi-group coordination effort from various divisions within a business enterprise: business, operations, technology, finance and compliance.
The compliance department, most likely with the cooperation of the in-house counsel (and outside counsel who specializes in FATCA compliance, if in-house counsel lacks such knowledge) should lay out the FATCA compliance goals and make sure that the FATCA compliance process complies with these goals. The operations division should create the framework for the FATCA compliance process, including how this process should be controlled and managed for tax reporting and tax withholding purposes. The technology division needs to build the IT infrastructure to address the technological challenges of FATCA goals in a cost-effective way. The members of the business division (which incorporates the actual customer intake) should be thoroughly educated in the FATCA compliance process as well as the company’s specific IT solutions.
When this FATCA compliance process is applied to the hedge fund industry, one can clearly see the numerous challenges that the hedge funds face in the implementation of their FATCA compliance. The hedge funds need to register their funds for FATCA on the IRS portal, gather various investor data with respect to numerous (and often changing) customers, review and assess such data, and properly report customer data to the IRS.
Another challenge for hedge funds is the required tax withholding. Unlike previous attempts at international tax legislation, FATCA has very effective enforcement mechanisms which forces all US banks, brokers and financial institutions to essentially work for the IRS, including withholding taxes. In fact, the hedge funds that deal in US dollars are likely to be subject to the withholding tax requirement at an increasing rate in the near future.
However, the tax withholding challenge for hedge funds goes far beyond the more straightforward fact that it will need to withhold tax. Rather, the biggest headache for hedge funds is the identification of the beneficial owners and controlling persons of their clients. A lot of investors in hedge funds operate through unregulated legal vehicles or individual agents; this fact makes the FATCA data collection process a much more difficult challenge for hedge funds.
Impact of FATCA Compliance By Hedge Funds On US Taxpayers
Despite these challenges, many hedge funds are successfully addressing FATCA compliance issues and are incorporating advanced software solutions to make their look-through process more efficient.
These successes of hedge funds in their FATCA compliance make it difficult for US persons investing in mutual funds through foreign entities to conceal their ownership of these entities. This means that one can expect an increase of the IRS discovery of such investors.
If these investors are not in full compliance with their US tax obligations – particularly with respect to FBAR, Form 8938, foreign business ownership reporting, foreign trust ownership and foreign income disclosure – they may be facing catastrophic US tax consequences, including draconian FBAR willful penalties as well as potential imprisonment.
Contact Sherayzen Law Office for Help With Undisclosed Foreign Assets and Income
If you have undisclosed foreign assets or foreign income, please contact Sherayzen Law Office as soon as possible. After reviewing the facts of your case and analyzing the available voluntary disclosure options, our team of tax professionals will conduct your voluntary disclosure process from the beginning through the end, including the preparation all of the required legal documents and tax forms.