The “Hiring Incentives to Restore Employment Act of 2010” (the HIRE Act) may be the broadest tax and information reporting legislation ever enacted, potentially affecting all investors whether individuals, trusts, family offices, or other entities and virtually all non-US banks, investment houses, brokerages, custody agents, mutual funds, hedge funds, private equity funds and life insurance providers, among others, with any investments in the US.
The Hire Act, enacted this March, left a number of issues to be determined at the discretion of the IRS and the US Treasury. Since its enactment, US and non-US investors and the non-US financial institutions and funds through which they invest have speculated as to whether regulations would be issued to limit the broad impact of this client identification legislation, and what these limitations and exceptions might be.
On its face, the HIRE Act requires any entity classified as a "foreign financial institution" (FFI) (extremely broadly defined) to either enter into an arrangement by which the FFI agrees to determine which of its account holders are US citizens, green card holders or tax residents (US persons), or entities which are substantially owned by US persons, or suffer 30 per cent gross withholding on all amounts invested into the US. The withholding would apply to virtually all amounts invested by the FFI into the US, whether for its own account or for the account of its account holders, regardless of whether or not they were US persons.
Earlier this week, the IRS issued the first formal guidance on certain priority issues relating to these new provisions. IRS Notice 2010-60, which contains this preliminary guidance, will be published in the Internal Revenue Bulletin dated 13 September 2010. Highlights of certain aspects of the Notice follow:
Trusts and Trust Companies
The Notice confirms that non-US trust companies are classified as FFIs (just like banks, financial institutions and brokerages, etc). Thus, absent a special exemption being issued in future guidance, any trust company not signing up to an FFI agreement (which would require it to determine whether its trusts, settlors and / or beneficiaries are US persons) would suffer 30 per cent withholding on virtually all investments into the US with respect to any and all trusts for which they serve as trustee.
The Notice also implies, but does not specifically state, that individual trusts themselves would be classified as FFIs; though it also suggests that "small" family trusts might be exempted from this classification, as discussed below.
If accurate, each individual trust with US investments would have to enter into an FFI agreement in order to avoid 30 per cent withholding on those investments. Further clarification is needed in this area. In the view of Withers, such treatment would be completely unnecessary to facilitate the goals of the HIRE Act and would be overly burdensome on the individual trusts and the IRS. It also would render meaningless certain other related provisions of the legislation with respect to determining beneficial ownership of trust structures.
Trusts and Family Investment Entities
The notice clarifies that certain trusts and family investment entities that have a "small number" of direct and indirect owners or beneficiaries may be exempted from the requirement that they enter into an FFI agreement if: (i) the withholding agent specifically identifies each individual, specified US person, and "excepted" NFFE (broadly speaking an NFFE is any non-US entity which is not an FFI or otherwise exempted; thus an excepted NFFE would not be subject to US withholding tax under this regime) that holds a direct or indirect interest in such an entity; (ii) the withholding agent obtains the documentation they would otherwise have been required to obtain had each such person been a new account holder or direct payee of the withholding agent; and (iii) the withholding agent reports the identity of any specified US Person identified as holding an interest in the entity to the IRS.
The IRS has also requested comments as to whether certain "small FFIs" should simply be treated as NFFEs, rather than FFIs, regardless of whether the withholding agents determine the direct and indirect owners of such entities. Any entity classified as an NFFE would, nevertheless, still be subject to FFIs having to identify the beneficial owners of the NFFE under the account holder identification procedures set out below.
The Notice contains a request for comments regarding which non-US entities, including charitable and certain other organizations, should be deemed to pose a low risk of tax evasion and, thus, should be excluded from withholding under the FFI regime, but as of yet there is no definitive guidance as to what the criteria will be to qualify for this exception.
Insurance companies that do not issue cash-value life insurance, annuities, or similar instruments (other than term life contracts without cash value) will not generally be considered "financial institutions" subject to this regime.
However, the IRS has requested additional comments regarding insurance companies that issue "cash value" insurance or annuity contracts. Following the legislative history to the HIRE Act, the Notice requests comments on whether and how cash value life insurance and annuity products should be treated. While speculative, it seems likely that non-US insurance companies offering life insurance products (other than term policies with no cash value) and annuity products will be classified as FFIs. Consequently they would need to choose between identifying their US account holders and disclosing those individuals or entities to the IRS or suffering 30 per cent withholding or all US investments.
The fund industry has submitted detailed comments to the Treasury and IRS indicating that in many instances funds themselves prohibit sale to US investors.
The Notice indicates that consideration is being given to whether these procedures might form the basis for exempting funds from FFI related requirements. However, comments have specifically been requested as to whether these US investor restrictions meet the definition of a US person as set out for US tax purposes (presumably as opposed to US securities law purposes), the extent of KYC/AML due diligence required, as well as whether any such restrictions would limit investment in such funds by non-participating FFIs.
Although it remains a possibility that certain funds ultimately may be exempted, the Notice implicitly suggests that the local regulatory regime applicable to the fund would need to impose comprehensive due diligence requirements with respect to determining whether any direct or indirect owners are US persons before the IRS would consider implementing any such exception.
The following entities will be exempt from the FFI regime, and will also be exempt from US withholding under the parallel regime applicable to certain non-financial foreign entities (NFFEs): (i) certain holding companies for non-financial enterprises (but not an entity functioning as an investment fund); (ii) start-up companies (other than financial institutions) for the first 24 months after their organization; (iii) non-financial entities liquidating or emerging from bankruptcy or reorganization; (iv) hedging/financing centres of a non-financial corporate group.
Account Holder Identification Procedures
The Notice provides preliminary guidance as to the procedures FFIs will have to undertake in determining which account holders are or may be US persons. These due diligence procedures are somewhat less stringent for pre-existing accounts, as opposed to new accounts.
Further important distinctions are drawn between accounts directly held by individuals, as opposed to accounts held by entities (e.g., companies and, perhaps, trusts and foundations - assuming that they are not themselves treated as FFIs). The following highlights certain elements of the identification process (which each have five or more separate steps as set out in the Notice).
Accounts Held by Individuals
If the account holder's average balances are less than $50,000 in the calendar year prior to the effective date of these provisions, an FFI can elect to exclude that account under the de minimis exception. For all other accounts, FFIs will need to search their electronic databases for indicia of US status (eg, declared citizenship, address, place of birth, instructions to transfer to US accounts, etc).
Where such indicia exist, the FFI would need to obtain verification of US or non-US status with the required verification depending on the type of indicia of US status. Where the account holder has a US passport, a US address (other than a "care of" or "hold mail" address), or a US place of birth, the account holder would have to provide a Form W-8BEN (certifying that they are not classified as a US person for US tax purposes) and provide a non-US passport or other similar evidence establishing non-US status. Where there are other indicia of US status, the FFI could generally rely on a Form W-8BEN provided by the account holder without needing to obtain other corroborating evidence (although other documentary evidence could be accepted in lieu of a Form W-8BEN).
All pre-existing accounts over $1 million must be treated as new accounts within two years of entering into the FFI Agreement. Within five years, all pre-existing accounts must be treated as new accounts.
Documentary evidence must be obtained establishing the status of new account holders (unless they identify themselves as US persons in the first instance).
For all account holders claiming non-US status, the FFI must then cross-check this against "all other information collected in connection with" the new account holder. Where there are indicia that an account holder claiming non-US status has a US connection, further documentation must be obtained to establish their non-US status in a manner similar to the process set out above for pre-existing accounts.
Accounts Held by Entities
The FFI must first search its electronic files in order to determine whether such accounts are "US accounts, accounts of participating FFIs, accounts of deemed-compliant FFIs, account of non-participating FFIs...accounts of recalcitrant account holders, accounts of excepted NFFEs, accounts of other NFFEs, or other accounts" in order to establish whether or not the entity might be a US person or itself be an FFI.
Then, for non-US entity account holders which are not themselves FFIs, the FFI must specifically identify each individual and entity with an interest in such a non-US entity and obtain documentation establishing each such individual or entity's US or non-US status as if such person were a new individual account holder.
The same general principles apply, but the FFI must determine how to treat such accounts using all information available (regardless of whether in electronic form) to the FFI, regardless of whether such information is electronically searchable.
Where do we go from here?
The withholding obligations under the HIRE Act will take effect from 1 January 2013, but FFIs wishing to enter into client identification agreements will need to act immediately to begin the complicated task of implementing account holder identification processes. As such it will be imperative that additional guidance and more detailed proposed regulations be issued as soon as possible.