July 1 FATCA Effective Date Looms for Foreign Retirement Plans

Employee Benefits Alert

Perhaps the most complex, far-reaching, and peculiar set of rules in the history of the Internal Revenue Code will be implemented on July 1 of this year. Adopted in 2010 as part of the Hiring Incentives to Restore Employment (HIRE) Act, the Foreign Account Tax Compliance Act (FATCA) is intended to prevent tax evasion by wealthy individuals by forcing foreign financial institutions (FFIs) to "out" their U.S. accountholders to the Internal Revenue Service (IRS) by imposing a 30 percent withholding tax on U.S. source income earned on funds invested by nonparticipating FFIs. In addition, on January 1, 2017, withholding will be required on the gross proceeds from the sale of U.S. stock and bonds. Although employee benefit plan administrators may think "these rules certainly don't apply to me" or be completely unfamiliar with them, the definition of FFI is very broad and often includes non-U.S. retirement plans.

FFIs generally include depository institutions, custodial institutions, investment entities and certain insurance companies. This broad definition sweeps in many traditional employee benefit programs including non-U.S. retirement plans (whether defined benefit or defined compensation in design), non-U.S. executive and employee stock programs, and other benefit designs. Unless specifically excluded from FATCA's scope, these plans likely face substantial registration and compliance burdens under the law. In many cases, foreign benefit programs that are required to register with the IRS must do so before July 1, 2014.

Although the IRS recently announced that 2014 and 2015 will be treated as a "transition period," plan sponsors should promptly take steps to document the Chapter 4 status of plans and become FATCA-compliant as soon as possible. The transition relief described by the IRS in Notice 2014-33 provides a vague and subjective standard for determining whether the IRS will impose penalties on taxpayers for noncompliance. The IRS was clear in emphasizing, however, that transition relief is not a postponement of FATCA's effective date, and that penalties and strict liability for withholding failures may be imposed if appropriate. Moreover, FFIs should begin to withhold on the U.S. source interest and dividend income earned by plans as of July 1 if the plan fails to properly certify an acceptable Chapter 4 status.

This alert briefly describes the penalties for noncompliance with FATCA, exemptions for which retirement plans may qualify, the compliance obligations for retirement plans that do not qualify for an exemption, and the effect of noncompliance by the investment vehicles in which a retirement plan's assets are invested.

Substantial Penalties for Noncompliance

FATCA's goal is to provide for automatic reporting of foreign accounts held by U.S. taxpayers to the IRS, similar to Form 1099 and W-2 reporting. Because it is difficult for the U.S. government to force such reporting by FFIs that do not operate in the U.S., FATCA operates by imposing a 30 percent withholding tax on certain income paid to noncompliant FFIs. In general, the tax will be imposed initially on payments of interest, dividends, insurance premiums, and fees for financial services. And, as mentioned, the tax is expanded to include the gross proceeds from the sale of assets that can produce U.S.-source interest or dividend payments -- U.S. stocks and bonds.

This withholding tax has significant ramifications for foreign employee benefit plans regardless of whether U.S. citizens or residents participate in such plans. If the plan invests in U.S. stocks or bonds (both Treasury bonds and corporate bonds), any interest or dividend payments on those investments (and beginning in 2017, the amounts for which such investments are sold or otherwise disposed of) will be subject to withholding if the plan is not compliant with FATCA. Even if a plan is an exempt beneficial owner as described below, it may be subject to the withholding tax if it fails to document its status to withholding agents on Form W-8BEN-E.

Exempt Beneficial Owner Status

Fortunately, Treasury has recognized that many foreign retirement plans do not provide significant opportunities for tax avoidance. To minimize FATCA's burdens on such plans, the IRS has provided several means by which a non-U.S. retirement plan may qualify for exempt beneficial owner status. Although these exceptions are broad and will minimize the potential disruptions that FATCA could otherwise cause, employers must take care to: 

  • Identify all foreign benefit plans that are potentially subject to FATCA; 
  • Carefully consider whether each plan that is potentially subject to FATCA satisfies the requirements for exempt beneficial owner status; and 
  • Document the plan's status on Form W-8BEN-E and provide such form to investment funds, brokers, and others who make payments to the plan that are potentially subject to FATCA withholding.

Requirements for Exempt Beneficial Owner Status

Non-U.S. retirement plans may qualify for exempt beneficial owner status in one of two ways: under U.S. Treasury Regulations or under the terms of an Intergovernmental Agreement (IGA) between the United States and the jurisdiction in which the plan is located.

Regulatory Exempt Beneficial Owners

In general, Treasury Regulations provide five different exemptions for which a retirement plan may qualify: 

  • Retirement Fund Covered by a U.S. Tax Treaty: This exemption may apply if the retirement fund is located in a jurisdiction with which the United States has an income tax treaty. For the exemption to apply, the retirement fund must be entitled to the treaty benefits with respect to any income it derives from sources within the United States and it must have been established principally to provide or administer pension and retirement benefits. 
  • Broad Participation Retirement Fund: A retirement fund may qualify for this exemption if it is established to provide retirement and related benefits (e.g., disability and death benefits) to current or former employees and is regulated under the law of the country where it is located and reports annually to the government of such country on its beneficiaries. No single beneficiary may be entitled to more than five percent of the fund's assets. In addition, the fund must also satisfy one of a number of other requirements (e.g., at least 50 percent of total contributions must come from sponsoring employers, contributions are limited by reference to earned income of the employee or to $50,000 annually, the fund is exempt from tax on its investment income in the country in which it is located because of its status as a retirement or pension plan). 
  • Narrow Participation Retirement Fund: A retirement fund may qualify for this exemption if it is established to provide retirement and related benefits and has fewer than 50 participants. There are a number of additional conditions, including that the fund is regulated under the law of the country where it is located and reports annually to the government of such country on its beneficiaries. Also, individuals who are not residents of the country where the fund is established or operates cannot be entitled to more than 20 percent of the fund's assets. The plan may not be sponsored by an investment entity or a non-financial foreign entity that derives a substantial portion of its income from passive sources or whose assets are substantially held for the production of passive income. 
  • Retirement Fund Similar to a U.S. Qualified Plan: This exemption applies if the fund meets the requirements of Internal Revenue Code Section 401(a), except the plan is not funded by a trust that is created or organized in the United States.

Intergovernmental Agreement Exempt Beneficial Owners

The original approach to retirement plans was to make specific reference to exempt plans in Annex II of each IGA. For example, the U.S.-U.K. IGA specifically treats, among others, pension schemes registered with Her Majesty's Revenue and Customs (HMRC) under Part 4 of the Finance Act of 2004, Individual Savings Accounts as defined in the Individual Savings Account Regulations 1998, and Save as You Earn Share Option Schemes approved by HMRC under Schedule 3 Income Tax (Earnings and Pensions) Act 2003 as exempt beneficial owners. More recent IGAs, however, have abandoned this approach. Instead, recent IGAs merely repeat the regulatory exceptions discussed above.

Compliance Obligations for FFI Retirement Plans

If a non-U.S. retirement or deferred compensation plan does not qualify as an exempt beneficial owner, it will likely be considered an FFI under FATCA. As an FFI, a retirement plan will be subject to substantial compliance obligations, including registration with the IRS, due diligence requirements to identify accounts held by U.S. persons, and annual reporting on such accounts. Retirement plans in Model 1 IGA jurisdictions will generally perform annual reporting to the government of the country in which they are located, as opposed to the IRS. Given the compliance burdens that FFI retirement plans face, plan sponsors should consider whether it would be possible to amend the plan so that it qualifies for exempt beneficial owner status.

Even if a retirement plan is an FFI under FATCA, it may not be required to perform due diligence and report on all of its accounts. In addition to the plan-level exemptions described above, the Treasury Regulations (and the IGAs) include account-level exemptions. These exemptions generally apply if the account is regulated as a tax-favored personal retirement account or is registered or regulated as part of a retirement or pension plan, is subject to annual information reporting to the relevant tax authorities, and satisfies other requirements relating to the amount contributions (generally $50,000 annually or $1 million lifetime) and the timing of withdrawals.

Retirement Fund Investments

Under FATCA's definition of FFI, not only are brokers, banks, and other entities treated as FFIs, but so too are many collective investment vehicles in which retirement fund assets may be invested. For example, UK investment trusts, UCITS, and SICAVs (open-ended collective investment vehicles common in Europe) are themselves FFIs. This provides an additional concern for sponsors of plans that provide or utilize investments in these types of vehicles regardless of whether the plan itself is an FFI or an exempt beneficial owner. Specifically, plans should consider the FATCA compliance of each of the collective investment vehicles within their plans and how to address investment funds that are noncompliant.

Investment vehicles that accept investments only from retirement funds that are exempt beneficial owners under FATCA, may qualify as exempt beneficial owners themselves. In general, to qualify for such status the investment fund must earn income only for the benefit for retirement funds that qualify as exempt beneficial owners under on the above exemptions or under an IGA, or for certain retirement accounts that are excluded from the definition of financial accounts.

If a collective investment vehicle is noncompliant, plan participants who invest in such vehicles may see substantially diminished investment returns (and potentially the loss of principal in 2017) as payments of U.S.-source interest and dividends to the vehicle will be subject to withholding. Plan sponsors should consider limiting retirement fund investments to FATCA-compliant collective investment vehicles and vehicles that do not invest in the United States.

For more information, please contact:

Michael Lloyd, mlloyd@milchev.com, 202-626-1589

Michael Chittenden, mchittenden@milchev.com, 202-626-5814

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