Foreign Account Tax Compliant Act (FATCA)
ust like many other countries, the USA is dealing with a huge budget deficit (expenses are more than incomes). That's why the USA needs money. One of the possible sources of income is direct taxes, particularly income tax. But aren't the US citizens paying taxes? Yes! They do. If fact, they pay more in taxes than many other developed countries. But unlike, other countries U.S. taxation system is quite different, probably one of the unique in the world. To understand FATCA, we must understand the nature of taxation system in USA.
In general, there are two types of taxation systems: (1) Resident based taxation (RBT); and (2) Citizenship based taxation (CBT). These taxation systems can be applicable to all sort of taxes but we would be focussing on Income tax. Other types of taxes have other complexities and are out-of-scope of FATCA, hence we would not be discussing those in this article.
Most of the countries in the world follow a RBT system, wherein an income tax is imposed on the residents of the country, irrespective of their citizenship. Under this system, a simple rule is created to check whether a person is a resident or not during a particular period, usually a financial year. For example, in India, under the Income Tax Act, a resident is defined as anyone who has stayed in India for 182 days or more (There are other checks too, but we are not discussing those in this article). If anyone qualifies this test, he/she is defined as a resident under the Income tax act and needs to pay income tax in India. If he/she does not qualify this test, they do not need to pay tax in India. Under the RBT system, tax is not collected even on the income earned in the country. For example, an Indian citizen may be a non-resident for income tax purposes but may be earning income in India from rents, dividends from stocks, interest from bonds, etc. He/she does not need to pay taxes on these incomes as well under the RBT system.
Some citizens of India such as personnel's working in Merchant Navy and Foreign airlines may become "non-residents' for Indian taxation purposes as they may be working outside India for more than 182 days. Even though they are Indian citizens they are not required to pay taxes in India as they do not qualify under the tax payer's eligibility rules. In fact, many merchant navy personnel on contractual employment with foreign merchant navy carriers use this clause quite often. Their shipping liners may be registered in tax haven countries such as Bahamas, Honduras, etc., where the tax rates are quite low. If they are falling short of the 182 days clause, they can seek a contractual arrangement for a time-period which will allow them to be outside India for more than 182 days, thereby avoiding paying income tax in India, while at the same time paying a substantially low tax in the country of their employers.
Under CBT system, the tax is collected from citizens of the country irrespective of whether they are residents in that country or not. The main eligibility test for taxation purposes under this system is citizenship. The USA follows this system. Hence, US citizens, irrespective of whether they are living in USA or not, are supposed to pay taxes to the US government, even on the incomes earned by them in foreign lands. For example, a US citizen may be living, working and earning income in France. Such a person may have investments both in US and France. He/she is required pay taxes to the US government even on the income earned in France. Wait a minute! Wouldn't that become a double taxation issue? Such a person would surely be required to pay taxes in France (as France follows a RBT system) and will have to pay taxes to US also on the same income, just because he is an US citizen. Isn't that injustice? Well! don't worry! There is a clause. Such a person is required to pay taxes to the US government only if the foreign tax is less than the U.S. tax, independently within each category of earned income and passive income. In other words, the tax payable to US government will be the differential in taxes. If the tax paid in that other country (in our example, it is France) is less than the tax applicable in USA then the differential tax amount is payable to US government. What if the tax rate in that other country is more than the tax applicable in USA? Will the US government then return the differential to the person? The answer is no. If the tax rate is higher in France and lower in USA, the person need not pay any taxes to US government, but cannot expect any refund as well. In real, in the case of France and USA, the marginal income tax rate in France is 45%, while that of USA is 37%.
What about tax liability of residents in USA who are not US citizens? Are they not liable to pay taxes to the US government on incomes earned by them in USA? The answer is Yes. They are also required to pay taxes to the US government. They are not required to pay taxes to the respective countries they belong to as they become "non-residents" in their own country due to RBT system followed by them.
Only two countries in the world follow this CBT system - USA and Eritrea.
With the above understanding of the tax system in USA, let's now focus our attention on FATCA.
As stated earlier, the US is running a huge budget deficit (about 4% of its GDP or $800 billion annually). This deficit is increasing continuously over the years. It also has the largest external debt in the world as a percentage of GDP. Basically, it needs money. One of the ways to get it is income tax - not from US citizens and residents on their US incomes and US investments, as they are collecting it anyway; but from US citizen on their non-US incomes. Weren't they collecting this tax all these years? The answer is not fully. As per the Internal Revenue Service (IRS) (equivalent of Income Tax Department in other countries) there are many US citizens (both resident and non-resident of US) who have direct incomes from work and passive incomes from investments outside US in various financial and non-financial assets but are not disclosing it to the authorities and thereby not paying taxes on them. The following are the type of incomes that are under contention.
- Direct income earned by US non-residents from work.
- Passive income earned by US non-residents from investments abroad.
- Passive income earned by US citizens from investments abroad.
Out of the above, the first two type of incomes are not an issue. As discussed earlier, the tax payable on the income by US non-residents is only the differential tax amount. Most of the US citizens who are living and earning in other countries have equivalent or higher tax structures. Even if the tax rate is lower in some countries, the potential tax collection is not much compared to the effort to collect such taxes. Moreover, there are other ways to collect them.
The below table shows the tax rates in various developed countries in 2019.
The issue is with the third type of income above - Passive income earned by US citizens from investments abroad. As per the US government estimates, it can potentially collect about $800 million in tax revenues a year from this source.
So the question now is: What is stopping the US government from collecting this tax? The answer is data. Many US citizens have not disclosed their investments in foreign countries (on financial and non-financial assets) and the incomes that they earn on them to the US government. So the IRS does not really know the quantum of assets that the US citizens hold in other countries and thereby do not know the potential revenue that it can earn from it in the form of taxes. The $800 million amount mentioned above is only an estimate as per some research. The actual assets and income is not known. Moreover, there are many US citizens who could be investors, dual citizens or legal immigrants. The complexities are many and what is required is good data.
So, how can the US get this data? The answer is: make it mandatory for US citizens to disclose it through a law; and that law is FATCA.
What is FATCA?
FATCA stands for Foreign Account Tax Compliant Act. It was enacted in 2010 for the purpose of detecting the non-US financial accounts of U.S. citizens and resident taxpayers and to enforce tax collections. In simple terms, it is a law for data collection, not for tax imposition. Data will be collected through FATCA, tax will be collected through the existing tax laws of IRS.
The obvious questions now are: Who, What, How, When, and all that sort of stuff. I have tried to explain these in the form of FAQ's below.
Who has to report?
What does US taxpayers mean?
- Certain US tax payers; and
- Foreign Financial Institutions (FIIs)
What is an Foreign Financial Institution (FFI)?
- U.S. citizens
- U.S. individual residents
- A limited number of non-residents
An FFI is a foreign financial institution, which is any non-U.S. entity that:
Generally, non-U.S. entities such as banks, broker/dealers, insurance companies, hedge funds, securitization vehicles, and private equity funds will be considered as FFIs.
Are there any exclusions in the type of FFIs?
- Accepts deposits in the ordinary course of a banking or similar business.
- As a substantial portion of its business, holds financial assets of 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 in such securities, partnership interests, or commodities.
- Is a specified insurance company; or
- Is a holding company or treasury center
Yes, there are. The following are the exclusions.
Who administers FATCA?
- Insurance companies that do not make payments with respect to cash value insurance or annuity contracts.
- Excepted non-financial group entities (e.g. holding companies, certain treasury centers, or certain captive finance companies).
- Excepted non-financial entities in liquidation or bankruptcy.
- Excepted inter-affiliate FFIs (entities that do not maintain financial accounts and do not hold an account with or receive payments from any withholding agent other than a member of their expanded affiliated group).
- Certain organisations falling under Section 501 © of the Internal Revenue Code (e.g. corporations organised under the act of Congress, title holding corporations for exempt organisations, labour agricultural and horticultural organisations, business leagues, chamber of commerce, real estate boards, etc.)
- Non-profit organisations that meet certain conditions.
The treasury department and the IRS.
What does reporting mean under FATCA?
Reporting means filing of the following forms annually with the IRS.
What are the reporting thresholds for filing Form 8938?
For individuals living in US:
- Form 8938 - required to be filed by certain U.S. taxpayers who hold foreign assets - reporting is only required if they meet or exceed the thresholds.
- Fin CEN Form 114 (Reporting of foreign bank and financial accounts (FBAR) - Required to be filed by certain U.S. persons who include U.S. citizens and U.S. residents or aliens, trusts, estates and domestic entities that have an interest in foreign financial accounts exceeding the reporting threshold of $10,000 at any time during the calendar year. This form is not filed with the federal tax return. It is filed electronically through Fin CENs BSE E-Filing system.
For individuals living outside US:
- If one is single or is married but files income tax returns separately from spouse = $50,000 of specified financial asset.
- If one is married and files income tax returns jointly with spouse = $400,000 of specified financial asset
What are the penalties for not reporting under FATCA?
- If one if single or is married but files income tax returns separately from spouse = $200,000 of specified financial asset.
- If one is married and files income tax returns jointly with spouse = $400,000 of specified financial assets.
The penalties for not filing Form 8938 are as follows:
- For failure to file on time = $10,000
- For failure to file after receiving non-filing notice from IRS = $10,000 for each 30 days delay
- Maximum penalty = $60,000
- Criminal penalties may apply.
The penalties for not filing Form 114 are as follows:
What does Specified Foreign Financial Asset mean?
- If not wilful defaulter = upto $10,000
- If wilful defaulter = upto the greater of $10,000 or 50% of account balances.
- Criminal penalties may also apply.
Specified foreign financial asset include:
As you can see, not all assets are included. Mostly, financial assets are included.
Are there any exemptions from reporting?
- Foreign stock
- Foreign securities, including deposits in foreign banks and institutions.
- Foreign financial instruments
- Contracts with non-U.S. persons
- Interest in foreign entities
The following persons are generally exempted from reporting.
- If a person does not qualify for filing income tax returns under IRS, then he need not file returns under FATCA.
- A beneficial interest in a foreign trust or a foreign estate, if you do not know or have reasons to know of the interest.
- An interest in a social security, social insurance, or similar program of a foreign government.
- If reporting is being done via other forms, example:
- Trusts and foreign gifts reported on Form 3520 or Form 3520-A
- Foreign corporations reported on Form 5471.
- Passive foreign investment companies reported on Form 8621
- Registered Canadian retirement savings plan reported on Form 8891.
I covered as many questions as I could possibly think of. But there is one more important thing that we need to discuss - the compliance by foreign banks, who have business in US. This is one of the most contentious issue in the entire law. It has also caused delays in the implementation of FATCA.
FATCA not just covers US banks and their branches in foreign soil, but also foreign banks who operated in US or have investments in US securities. The law requires these foreign banks to provide certain details of US citizens in their countries who have accounts with them. For example, consider the case of Deutsche Bank of Germany (I could have selected any other bank as well. I picked up this bank randomly for this example)
. Deutsche Bank in Germany has many branches. Some of its customers could be US citizens who are living in Germany due to employment or business reasons. These people, over the years, might have made investments in German securities such as German stocks, bonds, mutual funds, ETFs, savings bank accounts, fixed deposits, etc. On these investments, they may be getting some income. FATCA requires Deutsche Bank to provide the details of these investments (not income) to the Internal Revenue Service (IRS) of the US government. Deutsche Bank (head office) is regulated by the German banking laws. FATCA is a law of US. Why should Deutsche Bank comply with a law of another land? Can't it simply ignore FATCA and not provide the information to the US?. The answer is: Yes, It can, but at a cost or penalty. The penalty is: If Deutsche Bank does not comply with FATCA law then on incomes that accrue to Deutsche Bank from any investments made by it or its clients in US securities such as stocks bonds, mutual funds, real-estate, etc., the US banks (its own branch or any other bank with which it has corresponding banking facilities in US) will mandatorily deduct 30% withholding tax. The withholding tax also applies to any capital gains from sale of assets. If it complies with FATCA and provides the US with the required information then no withholding tax is deducted. The withholding tax of 30% is quite high and hence many banks all over the world (like Deutsche Bank) would comply with the law rather than avoid it.
You might have seen the impact of the above law locally on Indian banks too. If you have opened any account with an Indian bank in the last few years, you might have been asked by the bank to fill a FATCA-CRS Declaration Form. In case, if you have never bothered to read its contents (as I did not when I opened my account)
then please find below the terms and conditions of the form of an Indian bank.
The Central Board of Direct Taxes has notified on 7th August 2015 Rules 114F to 114H, as part of the Income-Tax Rules, 1962, which Rules require Indian Financial Institutions, such as the Bank to seek additional personal, tax and beneficial owner information and certain certifications and documentation from all our account holders. In relevant cases, information will have to be reported to tax authorities / appointed agencies / withholding agents for the purpose of ensuring appropriate withholding from the account or any proceeds in relation thereto. Should there be any change in any information provided by you, please ensure you advise us promptly, i.e. within 30 days. If you have any question about your tax residency, please contact your tax adviser. If you are an US citizen or resident or green-card holder, please include United States in the foreign country information field along with your US Tax Identification Number. It is mandatory to supply a TIN or functional equivalent if the country in which you are a tax resident issues such identifiers. If no TIN is yet available or has not yet been issued, please provide an explanation and attach this to the form."
If you read the above paragraphs carefully, you might have noticed that the declaration form is called as "FATCA-CRS Declaration". What is CRS? To understand that, let's tackle a fundamental question. Most of the countries in world are on RBT system. USA is the only big country that is on the CBT system. For its tax collection issues, it has passed a local law which requires banks and financial institutions in various countries to disclose information on assets held by US citizens. It expects all of these foreign banks and financial institutions to abide by its laws. What if all other countries also require information from US banks on details of assets held by its citizens? Would US comply with such requests?. This was one of the contentious issues that I was mentioning above. FATCA can only be successful if US also reciprocates to similar request for information made by other countries. Otherwise, its implementation is doubtful, as it also involves issues such as local data privacy laws. Therefore, in order to have a reciprocate information exchange, many countries have agreed to a system known as Common Reporting Standard (CRS). The CRS allows for automatic exchange of information between tax authorities. It is a critical tool in the world wide fight against tax evasion. To date, more than 100 jurisdictions have committed to adopting the CRS. Practically, this means that information of any foreign citizen can be sent to his/her respective local governments if they are participating in the CRS system.
END OF MY NOTES