FATCA: Four Steps to Meeting IRS Reporting Requirements

When the US Treasury made foreign financial institutions responsible for catching potential American tax evaders overseas, it also gave them a major migraine they are now finding difficult to alleviate.

Determining with certainty who is responsible for paying US taxes just became their job. If they choose not to cooperate with the US’s  Foreign Account Tax Compliance Act (FATCA), those firms and their clients face penalties of a high involuntary witholding tax on all income and gross proceeds from the US. 

Verifying whether or not their existing account holders meet the US Internal Revenue Service (IRS) criteria for US persons receiving US-sourced income — for which they must be taxed — requires intense scrutiny into their own records and collection of information from clients who may or may not be cooperative. Not to mention the detailed recordkeeping and reporting to prove their compliance.

Naturally, there is a lot of tax revenue at stake, although the cost of compliance will far exceed any revenues the IRS ever collects, according to projections by the foreign financial institutions (FFIs). Over 300,000 FFIs– investment managers, hedge fund managers, broker-dealers and banks — will likely fall under the IRS’ watchful eye and will have to send information on US persons with US-sourced income either directly the IRS or their own tax authorities who will forward it to the IRS, depending on what kind of intergovernmental agreement their government has with the IRS.

“Either way they must ensure the data is accurate,” warned Jeffrey Locke, director at global consultancy Navigant speaking at a recent event on FATCA in New York hosted by the Association of Certified Financial Crime Specialists (ACFCS).

Just creating a internal program to comply with FATCA is the first massive hurdle for many firms. A checklist of the four basic steps was offered by Locke and others at the ACFCS gathering for compliance, IT and operations specialists to follow. These specialists are on the front-lines of FATCA preparedness and based on what they tell FinOps Report that they aren’t looking forward to it. “We will have to dig through our technology and workflow procedures for sources of customer documentation,” said one compliance manager from a New York fund management firm. “It will all come down to 20 percent IT and 80 percent sweat.”

These four steps may not be everything needed to create a foolproof compliance process, but it can go a long way to forming a funnel of sorts for FFIs to collect the various data requirements and sort out the US persons that should be reported. The experts estimate that collecting the information on any client may take as much as several months to complete, and they advise the FFIs to start early in order to meet the July 1, 2016 deadline to complete analysis for all preexisting accounts. About 30 percent of client files will likely need extra info to fill in the gaps, estimates Siddharth Sakhardande, associate director of banking and financial services at global information technology consultancy Mindtree in Warren, NJ. The reason: most financial institutions may not have the necessary data available in their customer master files because of insufficient client onboarding processes, manual processes and legacy platforms.

Here are the four workflow steps suggested by the experts:

1. Collect the Data

To determine who meets the IRS’ definition of who must be reported, FFIs need to gather and organize all relevant account holder information. Easier said than done, as the data might be stored in multiple internal customer relationship management applications, multiple counterparty data applications, or even filed in office cabinets. Relying on some type of data aggregation technology is ideal for electronically stored information.

If an FFI can demonstrate it maintains all required information electronically, it may be eligible for an exception offered by FATCA to the need to search through paper records. If not, it will have to go through paper or scanned account files to complete its due diligence. This manual search will probably require a central location for collection of the files, and dedicated resources for combing through them.

“If data is only available in paper form and relationship managers or compliance managers are not able to obtain the appropriate know-your-customer information from speaking with the end client directly, the information will need to be physically obtained from various back offices, branches and hubs in a number of countries,” says Aaron Kahler, managing director of AML Compliance Advisors, a New York-based regulatory compliance and staffing firm.”Such a scenario will turn into a substantial remediation effort which will probably require financial firms to bring in consultants with FATCA expertise.”

Though smaller firms may have fewer potential US persons, they also are likely to face higher relative costs and efforts in complying with FATCA’s due diligence requirements. Most large financial institutions — namely banks and broker-dealers — should have a high percentage of the data in digital format, even if in multiple applications, allowing it to be aggregated. “Even if they don’t they will have deep enough pockets to invest in technology to convert the information into extractable data points,” says Sakhardande. “Smaller to mid-tier investment managers will have the hardest time because they will likely be the most-paper intensive and may not have invested in any electronic data aggregation mechanism.”

2. Categorize In-scope Accounts

Once client data has been collected, the FFI has to analyze it to identify who potentially may need to be reported. The categorization of in-scope accounts is based on the aggregate balance of the account holder. Individuals with accounts of at least US$50,000 in aggregate value may be subject to reporting, as may entities with at least US$250,000 in aggregate value. The aggregate value incorporates  depository accounts, custodial accounts, certain equity or debt instruments, and certain insurance and annuity contracts.

3. Identify US Indicia

An FFI must identify both US individuals and US entities and categorize them separately. Indicia is legal language for indicators that account holders should be reported to either the IRS or local tax authority. Fortunately, the IRS has come up with seven specific criteria to look for. Those seven criteria include a US street address, a US place of birth or US telephone number.

“The rules for further verifying the identity of the individuals or entities differ,” says Locke. “As a rule of thumb, they are more stringent for entities than individuals, and there are several dozen categories of entities each with their own due diligence requirements.” The due diligence requirements are the most stringent for what are known as passive non-financial foreign entities (passive NFFEs) or entities that do not actually produce income. Examples include certain types of trusts.

Because FATCA is such a complicated legislation, legal guidance may be necessary to interpret the categories  of entities and the due diligence required to verify the identities of owners or beneficiaries. Making matters more cumbersome for FFIs is that reporting requirements are also affected by the type of financial institution is doing the reporting, its location and business activities, as well as reporting restrictions that may exist in local laws.

“Meeting FATCA’s due diligence requirements could cause conflicts with local laws on privacy, disclosure, anti-discrimination and witholding taxes, subjecting the FFI to possible regulatory sanctions, civil lawsuits and criminal liabilities,” says Kahler. Intergovernmental agreements either signed or in the process of being signed by several dozen nations with the IRS go a long way to easing such concerns, but are still not a panacea.

4. Concentrate on Further Review

Once the individuals and entities believed to be liable for US taxes have been classified, the information must be verified before reporting can take place. “In the case of individuals with financial accounts of more than US$1 million, relying on documentation alone won’t be sufficient,” says Locke. “Relationship managers must answer some basic questions such as whether or not they know an individual is a US person.” To be certain, more work needs to be done. That means seeking additional information from an account holder such as IRS forms or written self-certification of its non-US status.

Ultimately, the financial institution might decide to close an account of a recalcitrant accountholder — one that fails to provide documentation required to determine its tax status within 90 days of a written request. “If a financial institution cannot identify the proper information internally and the client is not cooperating, closing the account with the appropriate audit trail is a proactive way to procedurally commit to complying with FATCA,” says Kahler.

Final words of advice: When in doubt, err on the side of caution. “We advise clients to be very careful and to not miss out on a potential US person who must be identified,” says Locke. “If you follow the IRS’ due diligence procedures, you should be on a good footing.”