July 27, 2012

TO: Distribution

FROM: Burt, Staples & Maner, LLP

RE: "Model 1" FATCA Intergovernmental Agreement ("IGA") May Show Direction of Final Regulations

One of the basic problems with FATCA has been that it imposes obligations on foreign financial institutions ("FFIs") that may contravene the laws of other jurisdictions, such as reporting information to the IRS or closing the accounts of uncooperative customers. IGAs are agreements between the U.S. and FATCA "Partner Countries" intended to allow "FATCA Partner Financial Institutions" ("Partner FIs") to comply with both FATCA and local law. Yesterday the U.S. government released two versions of the FATCA "Model 1" IGA ("Model").

The Two Versions. The Model provides that Partner FIs would report to their local government rather than to the IRS. One version provides that the U.S. and the Partner Country will exchange information about each other's taxpayers (the "reciprocal" version) and apparently will be used by France, Germany, Italy, Spain and the United Kingdom. The "nonreciprocal" version does not require the U.S. to share information with the Partner Country, and would be used if the U.S. believes that there are insufficient safeguards in the Partner Country to protect any transmitted information.

Where is "Model 2"? We also expect the U.S. to release a Model 2 IGA soon; that model would provide for reporting directly to the IRS, rather than the Partner Country. Japan and Switzerland announced last month that they would agree to Model 2 agreements.

Structure of the Model. The Model consists of three parts: a seven-article body, an annex covering due diligence, and another annex covering entities and accounts in each country that are considered to be outside the scope of FATCA reporting. Only the second annex is likely to differ substantially from country to country.

Limited Shelf Life? The Model anticipates that the parties will "consult in good faith" to amend the agreement to "reflect progress" on a variety of issues, including the treatment of withholding on "foreign passthru payments" and gross proceeds and the development of a common reporting and exchange model. In addition, the Model suggests that the parties will work with the OECD and, as appropriate, the EU to adapt the agreement to become a common model for automatic exchange of information and financial institution due diligence. Such "developments" are a two-edged sword for the industry. They could be beneficial if they lead to a less burdensome compliance approach. However, they could also require systems and procedures currently under development by Partner FIs to be substantially modified to reflect the "evolution" in the regime. The industry should work with these bodies to urge them to take into consideration that new requirements can lead to costly overhauls to systems and procedures and modify their governmental wish lists accordingly.

New "Category 3" FFI Definition. Both the proposed regulations and the Model impose much of the burden of FATCA compliance on "financial institutions" and largely define them in the same way – with one major exception. The Model replaces the "Category 3" FFI definition in the proposed regulations with a new "investment entity" category. The Model defines "investment entity" as "any entity that conducts as a business (or is managed by an 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;…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." The new definition both expands and contracts the concept of the Category 3 FFIs in important ways. First, entities that are not directly engaged in trading or investing in various assets, but only in managing such activities, will be treated as FIs under the Model (such as investment advisors and certain trustees). Second, small passive investment vehicles, such as family trusts and personal investment companies that are treated as Category 3 FFIs under the proposed regulations are not treated as financial institutions under the Model but will instead be treated as passive NFFEs unless they are being professionally managed. We believe that the Model's approach, which has been strongly urged by many in the financial industry, will ultimately be adopted by the final regulations to address the troubling repercussions of treating non-professionally managed investment companies, which can be quite small and unsophisticated, as "FFIs" with FATCA compliance obligations.

Due Diligence Similarities. Both the proposed regulations and the Model have distinct rules for individual and entity accounts which are further refined for preexisting and new accounts. Individual accounts of $1 million or less are subject to an electronic search for U.S. indicia, and accounts greater than $1 million are subject to a more thorough review, which may include asking relationship managers whether they know if the account has U.S. indicia. Preexisting individual accounts (and all individual depository accounts) of $50,000 or less and preexisting entity accounts of $250,000 or less generally can be excluded from FATCA duties. The procedures for dealing with U.S. indicia are also similar, and Forms W-8 would still be one of the more straightforward ways to cure that indicia.

Due Diligence Differences: Individuals. The Model is more permissive than the proposed regulations in the types of documents that can be used to establish an account holder's FATCA status. For example, to establish foreign individual status for a new account, the proposed regulations would require either a Form W-8BEN or government-issued identification (and require that "none of the documentation associated with the payee contains U.S. indicia"). On the other hand, the Model requires merely a "self-certification" that allows the Partner FI to determine whether the individual is a U.S. tax resident, and that the certification be reasonable in light of other account opening information, such AML/KYC documentation. The self-certification can be included in the account opening documents. There is no prescribed form, but Partner FIs will need a defined, reviewable process to obtain certifications. Forms W-8 and W-9 will remain an effective solution for doing so.

Due Diligence Differences: Entities.

Identification of Entity Type: A Partner FI can treat an entity as an Active NFFE or Partner FI (including from another Partner Country) on the basis of publicly available information or other information in the Partner FI's possession. Other entities can establish their status with a self-certification. Key to Partner FI compliance will be the ability to establish standardized processes for collecting, validating, and maintaining this documentation. As with individuals, Forms W-8 and W-9 continue to be a solution.

Change in NFFE Ownership Threshold: A Partner FI is not required to identify 10%-or-greater U.S. owners of an NFFE; rather, it must identify the "Controlling Persons" under the AML/KYC principles adopted by the FATCA Partner, which in many jurisdictions is a 25% ownership threshold. This is a highly welcomed change to conform the FATCA requirement with local AML/KYC requirements, as strongly advocated by the industry. The Partner FI must determine whether any of the Controlling Persons are U.S. individuals; if so, the account must be treated as a U.S. account.

The Search for U.S. Phone Numbers. The industry had hoped that U.S. phone numbers would be removed from the U.S. indicia list, but they remain a part of the Model. The final regulations are likely to also retain U.S. phone numbers as indicia of U.S. status and FATCA implementation projects should take this into account in designing search queries for electronic databases.

Deadlines Extended. The deadlines for completing preexisting account due diligence are later under the Model. The measuring date for new versus preexisting accounts is December 31, 2013, six months after the first wave of participating FFIs. High value individual accounts must be reviewed by the end of 2014 and other individual accounts must be reviewed by the end of 2015 (a six-month extension in both cases). Preexisting entity accounts must be reviewed by the end of 2015 (a six- or 18-month extension, depending on the type of entity). Partner FIs do not need to identify "prima facie" FFIs within one year of the effective date of its FFI Agreement as required by the proposed regulations. (See chart at the end of this letter.)

Information Exchange. Partner Countries and the U.S. are expected to exchange information for a calendar year within nine months of the year-end, except that the exchange for 2013 is delayed for an additional year to September 2015. There is no explicit deadline for Partner FIs to provide the information to their governments. In addition, the competent authorities of the parties will make further agreements governing the details of information exchange and other collaboration. (See chart at the end of this letter.)

Reporting. The Model reporting largely mirrors the proposed regulations with respect to reporting. Partner FIs must report account balances and amounts paid to account holders, except that they report to the Partner Country instead of the IRS. Like the proposed regulations, these obligations are phased in so that only balance information is required for 2013 and 2014, income payments are added for 2015, and gross proceeds paid to a custodial account are added for 2016 and subsequent years. We note, however, that the reporting for 2015 includes redemption payments made outside of a custodial account, and that these gross proceeds would not be reportable outside of a Partner Country. It is not clear whether this more burdensome result for Partner FIs was intended. In the reciprocity version of the Model, U.S. financial institutions are required to report to the IRS deposit interest and U.S. source payments, which is largely consistent with what they are required to do currently under U.S. law. Oddly, the Model does not state how withholding on U.S. source income amounts paid to NPFFIs should be reported. Presumably, such reporting will follow the proposed regulation rule of using Forms 1042-S.

Conditions for a Partner FI to Escape FATCA Withholding. Partner FIs must satisfy several key conditions to escape FATCA withholding on payments made to them – it is neither automatic by virtue of being located in a Partner Country nor absolute. Partner FIs must report on U.S. accounts annually, report payments to nonparticipating FFIs ("NPFFIs") for 2015 and 2016, comply with registration requirements, and either withhold 30% on U.S. source payments to NPFFIs or provide information to the withholding agent responsible for withholding. Significant noncompliance could cause a Partner FI to be treated as an NPFFI subject to full FATCA withholding and the IRS will apparently publish a list of such FIs. It remains uncertain, however, how the IRS would identify such non-compliance if the Partner Country is charged with overseeing the Partner FI's compliance, unless it is assumed that the Partner Country would proactively share such information with the IRS under its exchange agreement.

Defusing the "Limited" Time Bomb. Partner FIs that do everything required under the agreement are treated as complying with FATCA, even if branches in other countries or other members of their expanded affiliated group are not able to comply with FATCA. In the proposed regulations, the IRS would have temporarily allowed "Limited Branches" and "Limited Affiliates" until the end of 2015, but at that point the existence of even one Limited Branch or Affiliate would have prevented members of the group from maintaining participating FFI status, subjecting all FFIs in the group to 30% withholding under FATCA. The Model defuses the ticking time bomb of limited status. Partner FIs are, however, required to treat Limited Branches and Affiliates as NPFFIs and the branches and affiliates are required to identify and report upon U.S. accounts to the extent possible and to not solicit nonresident U.S. and NPFFI account holders. In addition, the branches and affiliates may not be used to circumvent the IGA or FATCA.

Withholding Limited to U.S. Source Income. A Partner FI's withholding obligation under the Model is limited to U.S. source income. Gross proceeds and foreign passthru payments are excluded from the definition of "U.S. source withholdable payment." In addition, no withholding is required on recalcitrant accounts at Partner FIs, and such accounts would not need to be closed. On the other hand, the parties agree "to work together, along with other partners, to develop a practical and effective alternative approach to achieve the policy objectives of foreign passthru payment and gross proceeds withholding that minimizes burden."

Reporting by USFIs. The U.S. has only committed to exchange information that USFIs are currently reporting to the IRS with regard to U.S. source income payments paid to direct account holders. They do not need to look through and report on the Partner Country owners of entities nor do they have to report on the account balances and other requirements that will be imposed on reporting of U.S. accounts by Partner FIs.

Conclusion. We view the publication of the Model as a positive development given the severe conflict of law problems that have plagued FATCA implementation projects since day one. However, it is clear that Partner FIs continue to have substantial FATCA compliance obligations and significant downsides if they fail to meet them. The IGAs are hardly an "out" from FATCA. Financial institutions should carefully assess the differences between the Model and the proposed regulations to read the tea leaves as to what the final regulations may well contain; U.S. officials have stated publicly that their goal is to have uniform due diligence and reporting requirements under both the IGAs and the regulations. To the extent that they miss their target of uniformity, FATCA implementation plans will need to be modified to take these differences into account.

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