The Foreign Account Tax Compliance Act (FATCA) was implemented by the US Treasury in 2010 to combat tax evasion and support global AML efforts. It requires foreign banks and financial institutions to report accounts and assets held by their customers who are US citizens to the IRS. Failure to report these assets comes with harsh penalties for both individual taxpayers and FIs. FATCA processes have overlap with mandatory KYC processes.
Many Americans have strong feelings about paying taxes, and some have taken great pains over the years to avoid paying their fair share. One longstanding method of evading taxes is to stash cash in foreign banks and foreign financial institutions (FFIs).
But tax evasion wasn’t the only reason some Americans were stowing their cash overseas. Many criminals do this to hide their ill-gotten money, and over time it became a popular way for money launderers and traffickers to hide the proceeds from their schemes.
In order to combat tax evasion and support global AML efforts, the US Treasury implemented the Foreign Account Tax Compliance Act (FATCA) in 2010, which is administered by FinCEN.
What exactly does it do and who is affected by it? Let’s break it down.
FATCA requires foreign banks and other foreign financial institutions to report the foreign assets held by their American account holders to the IRS. Each participating country must sign an Intergovernmental Agreement (IGA) to report these assets and comply with a specific set of reporting and withholding requirements; there are currently 113 countries that have some form of a FATCA agreement with the US. FFIs that fail to report will be levied a 30% withholdings tax on certain payments from the US.
Individual taxpayers are also expected to abide by FATCA. There are a few different ways for them to be considered noncompliant – and the penalties are stiff.
FFIs with customers who are US citizens must report those customers’ accounts to the IRS. Additionally, US citizens, residents, and certain non-residents must fill out Form 8938 and file it with their tax return if the value of the assets meet a certain threshold.
There are a number of them, including:
FFIs with clients who are US citizens who own these assets through their institutions must report them to the IRS to remain compliant.
While FATCA doesn’t require FFIs to make specific changes to their know your customer (KYC) processes, it does require that any information gathered during KYC that indicates the customer is a US citizen be reported. This means FFIs must have internal processes in place that pass along this information to their internal tax operations team or other relevant team(s) to avoid noncompliance.
FFIs must also report customers who are US citizens and “substantial owners” of foreign corporations, trusts, or partnerships. A US person qualifies as a substantial owner if they own more than 10% of the equity of a corporation, more than 10% of the profits of a partnership, or more than 10% of the beneficial interests in a foreign trust. Certain FFIs, such as hedge funds and private equity funds, must report every US owner to the IRS, as they’re all considered substantial owners.
It’s important for hedge funds which invest in US securities to do their due diligence to identify beneficial owners and determine which of them are US citizens and which of them may be direct or indirect owners of the entity investing in the hedge fund. If they don’t collect and report that information to the IRS, they risk getting hit with the withholding tax.
While it’s the responsibility of individual taxpayers to report their foreign assets to the IRS, it’s also important for FFIs to uphold their responsibility to FATCA to ensure these assets are being reported. Whether unintentionally or intentionally, some customers may not be reporting these assets to the IRS.
At a minimum, FFIs who remain FATCA compliant are doing their part to help minimize tax evasion. But they’re also making it much more difficult for potential financial criminals to stay under the radar and misuse and abuse the global financial system.
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