Most of the countries, including India, tax their residents on the worldwide income unlike the United States. In the United States, both US citizens as well as residents are taxed on their worldwide income. To give relief from the burden of double taxation it allows foreign taxes to be used as a credit against US tax. If a person's “Tax home” is in a foreign country and he/she meets the bona fide residence test or the physical presence test, then the person can choose to exclude from the income, a limited amount of the foreign earned income.

The US treasury has framed and re-framed laws to curb tax evasion in all possible ways. It introduced the Qualified Intermediary (QI) program in 2001 to enhance adequate taxation of US citizens who operate accounts outside the country. With the QI regime US became one of the first countries to set their vision on taxpayers' investments in foreign countries and demanded the taxpayers to disclose their income earned abroad. However, the QI regime had a limited scope and covered only certain assets like the US securities which were held directly by US persons who have their identities disclosed to the financial institutions.

Why the new Act

With the QI regime in place there was still a tax gap present. The tax gap is the difference between what is theoretically owed in taxes and what is actually collected in taxes. This lead to the legislation of the new Compliance act known as the Foreign Account Tax Compliance Act (FATCA).

Introduced as a part of the Hiring Incentives to Restore Employment (HIRE) Act, it aims to prevent US persons from evading tax through accounts held at Foreign Financial Institutions (FFIs) or through other Non-Financial Foreign Entities (NFFEs). . The US residents will have to disclose their investments and revenues they obtain from investments regardless of whether the investment is in US securities or not. The law does so by imposing tough new withholding tax on payments made to foreign entities. It provides for information reporting of US accounts held in foreign institutions by all FFIs.

Withholdable payments made to a FFI are subject to the 30 per cent FATCA withholding tax unless the FFI has entered into an agreement with the US Treasury that will require reporting of all US account holders of the FFI. It is anticipated that up to 250,000 Foreign Financial Institutions may enter into a compliance agreement under FATCA.

Entities other than Financial Institutions are categorized as Non-Financial Foreign Entities (NFFEs). A withholding agent is required to deduct and withhold a tax equal to 30 percent of any withholdable payment made to a NFFE, if they do not meet certain requirements under the FATCA regime. FATCA requires all FFIs and the NFFEs who want to be in trade terms with the United States to enter into a contract with the US Treasury. By doing so the institutions undertake to identify US customers and report their assets to the US Government.

Compliance with FATCA

Let us take an example of a bank in India, which invests or does business dealings with entities in the United States. If this bank wants to continue its business transactions with the US it must sign the Information Reporting Agreement under FATCA with the US Treasury or suffer a penalty of 30 per cent withholding tax which will be imposed on all payments it has to receive from the U.S. entity. Withholdable payments include US source interest, dividends, royalties, rents, and other fixed determinable annual or periodic income and gross proceeds from the disposition of property that can produce interest or dividends.

Let us take another example of an Indian financial institution which does not invest directly in the US but invests in an investment vehicle of an institution in UK which further invests in US. Now since the UK firm is investing in the US financial institution, the Indian firm would also come under the influence of FATCA. In this scenario, both the UK firm and the Indian firm might suffer a 30 per cent penalty of withholding tax if they are not FATCA-compliant.

Changes in KYC norms

India's current “Know your customer” (KYC) norms and application process may not be sufficient to identify US citizens and residents. Therefore the implementation of FATCA will bring significant changes to the current account opening processes, transaction processing systems and the KYC procedures followed by Indian Financial Institutions. Once an organisation has identified the accounts, it needs to determine an ongoing reporting, testing, and monitoring process to sustain compliance with FATCA.

Not to register is not really an option even if the 30 per cent% withholding is irrelevant to some FFIs. The reason is that in the medium to long run such FFIs will find themselves marginalized.

Register and follow the regulations which may require extensive reporting to US Treasury. The challenge then will be to identify US persons, and report accurately in a time bound manner as also to desist from doing business with unregistered FFIs. This will result in making several changes to systems, processes, procedures to identify US persons, extract information on relevant income and to monitor such accounts on an ongoing basis. There are other related conditions precedent, for example getting waivers from customers to report to US authorities, communication to customers about FATCA, advising the Board of Directors, communicating within the FFI, what to do and when with customers who refuse to provide information.

Lead time

The FATCA provisions will take effect from January 1, 2013. However the full impact of the compliance burden of this legislation will not be clear until complete regulatory guidance is issued by the US tax authorities. By 2015, FFIs are expected to treat accounts with an average monthly balance of greater than $ one million that have failed to provide documentation as recalcitrant account holders. By 2018, FFIs are expected to treat all accounts with a balance of greater than $50,000 that have failed to provide documentation as recalcitrant account holders

The date of applicability being January 2013, FFIs feel that they have time. In some respects yes, as the regulations are yet being fleshed out. They can use this time to analyse the business impact, for example cost of compliance, impact on technology changes, impact on customers and brand, impact of moving out of business relationships like conduct an impact assessment.

FFIs can start creating basic scenarios and actions that they would have to therefore undertake, for example, increased US-driven KYC requirements. The cost of customer communication can be enormous if done in a piecemeal manner.

Since FATCA will affect any foreign investment vehicle that receives directly or indirectly, any US source income, it is expected that sooner or later all Indian financial institutions will align themselves with the FATCA norms.

It is quite possible that other countries may come up with similar reporting requirements as a forward looking best practice. Compliance with FATCA's due diligence, verification and annual reporting may result in conflicts with local privacy laws and regulations of a country. Given the nature of FATCA regulation, the Indian regulatory authorities may be required to play an important role to safeguard the Indian industry against undue exploitation. Indian financial institutions and non-financial entities may require assistance with the reclaim and refund process which may arise due to extra or wrongful withholding.

(The author is a Senior Director with Deloitte Touche Tohmatsu India Pvt Ltd.)

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