The X-FATCA... or why you might be an ‘accidental’ financial institution and not even know it

30 November 2017

Paul Crean, CA, Financial Services Tax Principal |

Speed Read

The Automatic Exchange of Information (AEOI) obligations are imposed on Australian Financial Institutions (FIs) under domestic Australian legislation.  The AEOI regimes comprise both the Foreign Account Tax Compliance Act (FATCA) and the Common Reporting Standard (CRS) and require Australian entities to exchange financial account information with tax authorities around the world.  FATCA has been in force since 2014; however, the CRS entered into force from 1 July 2017 and is likely to have a substantially greater impact than FATCA which only targets U.S. tax payers.

In essence, FIs have to identify customers and investors who are tax resident outside AUSTRALIAN, collect their financial and personal data and report to the HMRC on an annual basis.

Many Australian entities will find themselves unexpectedly classified as FIs under this legislation and urgently need to consider the implications as a result.  The term FI includes funds, private equity groups, investment advisers, trusts & corporate trustees, brokers, spread-betters, custodians, certain insurance entities, personal investment companies, managed funds, charities, real estate groups and others.  AEOI does not affect just banks and building societies. 

To summarise, a Reporting FI must review its financial accounts to identify reportable accounts by applying due diligence rules and then report the relevant information.

Background to the global exchange of financial information: how did we get here?

In the post-crash world, the U.S. concluded that U.S. taxpayers were holding billions of dollars of taxable assets overseas and decided to use overseas i.e. non-U.S. FIs as the mechanism for obtaining information about these assets.

Under FATCA, since 2015 FIs have had to report to the IRS details on financial accounts held outside the U.S. by U.S. persons. 

There was a fairly long stand-off period while the extra-territorial nature of this U.S. legislation was digested until the rest of the world effectively signed up to the idea, literally and figuratively.    Many countries including Australia now have intergovernmental agreements in place with the U.S. under the provisions of which the identification and reporting of financial accounts takes place.

More than 5,000 Australian entities have registered for FATCA, at the time of writing, but without doubt there are many more than have not yet realised they are FIs with a requirement to register and potentially report.  If so, they have already missed three FATCA reporting cycles with the most recent date being 31 July 2017. 

Not only do FATCA (and CRS) form part of domestic Australian law - and therefore compliance is a legal obligation - failure to report, incomplete reporting or the absence of maintaining appropriate records bring with it administrative penalties.  In addition, such deficiencies may also give rise to scrutiny from the tax authorities who, after all, now have a list of registered FIs against which to check those that have submitted reports, (and those that haven’t!)  

Furthermore, experience indicates that many entities which did register with the IRS did so without fully considering the obligations of what being an FFI meant.  These obligations will now substantially increase under CRS.

Finally, where entities have failed to classify themselves under FATCA and have not registered or which have incorrectly classified themselves, they may find commercial difficulties when transacting with other organisations that will demand this information. 

What is the CRS and how is it similar (and different) to FATCA?

Having somewhat reluctantly accepted FATCA, the rest of the world slowly began to appreciate the potential benefit of doing something analogous in order to obtain financial data about the offshore assets of its own taxpayers.

Initiated by the OECD and the G20, the CRS is a single, global common reporting standard designed to act as the mechanism for the automatic exchange of information between multiple countries.  Australia has signed the Multilateral Competent Authority Agreement on Automatic Exchange of Financial Account Information which facilitates the implementation of the CRS. 

Under CRS legislation to date, the Australian government has committed to exchanging information with 41 other countries.   CRS in AUSTRALIAN came into force from 1 July 2017 with the first reporting deadline being 31 July 2018

As with FATCA, CRS is a somewhat peculiar hybrid of tax (domestic and international), compliance and legal.  As a result, it is not uncommon for a lack of clarity to exist initially within organisations as to who has responsibility for the legislation and how it should be managed.

Procedures to be in place from 1 July 2017

From 1 July 2017, Australian FIs had to have processes in place to identify the tax residency of all financial account holders i.e. new customers (and/or investors) and, where these are found to be non-Australian tax resident, report personal and financial information to the HMRC for onward submission to the tax authorities of the countries in which the account holders are tax resident.

For their ‘back-book’ of financial account holders i.e. customer and investor accounts already in existence before 1 July 2017, FIs have had to review the position in line with prescribed due diligence requirements and again, where account holders are identified as non-Australian resident, there will be reporting obligations.

It is therefore clear that CRS is far wider in scope than FATCA, targeting as it does not only U.S. accounts holders but all non-resident account holders.  In addition, a number of the concessions or excluded categories that exist under FATCA have not been replicated under CRS. 

For example, there are very limited de minimis thresholds under CRS below which financial accounts need not be examined.  There are also few exempted FIs e.g., unlike FATCA, charitable foundations and trusts are not automatically excluded and may find themselves classified as Reporting FIs.  It is not hard to imagine that many charities will be unhappy to find themselves categorized in this way.  The concept of ‘accidental’ or at least ‘unsuspecting’ FI status is a real feature of this legislation.

In summary, an Australian FI has to identify all customers/investors not living in Australia but who have funds or money with invested with it in some fashion and report details of the financial account and the holder to the HMRC.  Furthermore, it has to do this on an annual basis starting from May 2017.

What are the key challenges of CRS?

At a high-level, the proposition sounds relatively straight-forward.  However, on closer examination there are a number of obvious challenges:

  • The requirement to ‘look behind’ certain entity account holders to verify the ‘natural persons’ who control them;
  • Definition of ‘control’ for a myriad of different types of organisations and structures;
  • The definition of financial account given its wide application and inclusion of equity interests in partnerships and settlors & beneficiaries of trusts;
  • Periodic changes to customers’/investors’ country of tax residence (not something that had to be considered under FATCA);
  • Managing investor/customer relations;
  • Training staff;
  • Responsibility for implementing and delivering the legislation in-house including review of existing legal terms & conditions with current service providers;
  • Changes to IT systems;
  • Differentiating between the requirements of FATCA and the more extensive CRS requirements (e.g. different de minimis thresholds);
  • The challenge of obtaining self-certifications from customers/investors to determine their correct AEOI classifications;
  • Managing different interpretations of the legislation in the case of multinational groups; and
  • Understanding the legislation in the first place!

The U.S. could have elected to join the CRS but has currently decided to maintain FATCA as a separate reporting system which will run in parallel.  As a result, FIs now have two systems to contend with that are similar in many ways but far from identical.

How do I determine whether I am an FI under CRS (and FATCA)?

Does an entity exist?

In order for there to be an FI, there first has to be an ‘entity’.  The question therefore arises as to what exactly is an entity and, as a secondary issue, can the tax status of an entity affect its FATCA/CRS status?

In this context, an entity is a legal person (which excludes a natural person) or any form of legal arrangement.  Individuals can never be entities.  With regards to tax status, this should be subdivided into (i) how an entity is taxed and (ii) where an entity is taxed.

First, it is irrelevant under either CRS or FATCA whether an entity is tax transparent or not.  The legislation looks to impose a reporting burden on a legal entity basis however constituted.  Consequently, the reporting FIs within a group will be the legal entities/arrangements however constituted including trusts and partnerships which may or may not overlap with the taxpaying entities. 

Where an entity is nonetheless a taxable person, e.g. a company, then its place of tax residence dictates the regime under which it is reported and the tax authorities through which the financial account information is reportable.

What are the categories of FI?

Having established that an entity exists, we then move to its classification.  The FI definition is widely drawn and not limited to the depository or custodial institutions that people might typically expect.   Many entities will therefore have to consider carefully what their correct AEOI classification should be.  Determination can be a far from straight-forward process as each group has its own peculiarities and internal structure which does not necessarily fit neatly within the definition in the legislation. Even where entities conclude that they are not Reporting FIs, they may still find that they have responsibility for the management or administration of one or more FIs.

While it is true that banks, credit unions, building societies, life insurance and custodians fall within the definition, regulation by the PRA and FCA is not of itself a pre-requisite for being caught.   There are many unregulated, ‘accidental’ and unsuspecting financial institutions as mentioned above. 

In addition to the FI classification of depository or custodial institution, a key FI definition to consider is the ‘investment entity’ definition, namely an entity is one which:

  • invests, manages or administers funds or money on behalf of others; or
  • holds financial assets and is managed by a financial institution.

This means that a wide variety of entities and ‘legal arrangements of whatever type need to go through the process of considering the impact including:

  • trusts (even small family trusts) holding financial assets (stocks, shares, notes of indebtedness, derivatives etc.) that have a corporate trustee or whose assets are financially managed by a bank or asset management type firm;
  • brokers;
  • private equity houses;
  • venture capitalists;
  • collective investment vehicles (CIVs), carry vehicles and other entities within fund structures (limited partners, limited liability partnerships);
  • peer to peer lenders
  • personal investment companies (PICs) managed externally;
  • nominee companies, custodians and entities holding legal title to financial assets;
  • Investment trust companies;
  • spread betters, margin forex traders, traders in CFDs; and even
  • charities.

With regards to the definition of ‘financial assets’ this encompasses, but is not limited to, stocks and shares, interests in partnerships and trusts, bonds, debentures, swaps, derivatives, futures and forwards contacts.

All of the types of entities listed above can potentially be FIs.  Trusts, which are perhaps an example of unexpected FIs, can be caught depending on the type of assets they hold, how those assets are managed, by whom and the overall structure in the case of a wider group. 

E.g.1: A property may be held within a trust as means of asset protection.  Real estate is not a financial asset and therefore regardless of how the trust is managed the trust will not be an FI where this is the trust’s sole asset.  However, where a trust chooses to hold real estate through e.g. a company, the interest in that company is considered a financial asset.  If that trust then has a corporate trustee that carries on a business of managing the trust then the trust, and the corporate trustee, are both likely to be financial institutions.

E.g. 2:  Private equity (PE) structures frequently require detailed analysis.  A typical PE group would consist of the managed fund, a general partner, a carry vehicle, an investment manager/adviser and an (often unrelated) administrator.  Investors are likely to come into the structure at the fund level and the carry vehicle level.  Prima facie, each of these entities would fall within the investment entity definition set out above.  Consideration then must be given to whether any exemptions apply and how those exemptions might differ from tax jurisdiction to tax jurisdiction.

E.g. 3:  Brokerage services would clearly be regarded as involving the management or administration of funds or money.  However, brokers may simply offer execution only services or alternatively they may hold client money in e.g. margin accounts or offer custodial operations.  It is therefore necessary to consider carefully the exact services that this type of entity is carrying out.

Once we have established an FI exists, how do we identify financial accounts?

Although FATCA initially arose out of an investigation into bank accounts held in Switzerland, the architects of the FATCA/CRS legislation soon realised that there were many other forms of investment that existed and should be targeted.

Consequently, the term ‘financial account’ can take various forms including a bank or building society account, a custodial-type account, margin accounts which are common with spread-betting firms or brokers, and even equity and debt interest in managed funds, CIVs or trusts. 

The term Equity Interest in the case of a partnership that is an FI means either a capital or a profits interest in the partnership.  In the case of a trust that is an FI, an Equity Interest is considered held by any person treated as a settlor or a beneficiary of all or a portion of the trust or any other natural person exercising ultimate effective control over the trust.  Both mandatory and discretionary beneficiaries can be considered reportable persons

Notwithstanding the above, not all financial accounts are automatically reportable.  Certain exclusions exist for accounts that are considered low-risk or e.g. certain retirement savings accounts or share plans.  However, the majority of financial accounts will be reportable where held by non-residents particularly in the case of individual account holders where, under CRS, no de minimis balance threshold exists below which reporting is not required.

Verification and validation of reportable accounts, following the prescribed due diligence procedures, and identification of reportable financial information is too detailed to be covered in this article.  However, it is something which an FI should give thought to at this time particularly where it is likely to have a material numbers of customers.

Finally, it is worth noting that FIs are required to maintain details of the policies and procedures followed to ensure that they are implementing the legislation correctly and to be able to demonstrate this to the HMRC upon request.  As highlighted above, failure to do so brings with it administrative penalties as well as the likelihood that an absence of process will increase the chances of inaccurate reporting and further penalties.  (It is worth nothing that over-reporting, as well as under-reporting, of information may well bring its own problems if an FI incorrectly reports investor information to the tax authorities where this was not necessary.  Managing the concerns of worried customers should not be underestimated.)

What if I am not an FI?

Under AEOI, every entity has to have a classification of some sort.  FIs will be Reporting or Non-Reporting FIs.  Non FIs are either Passive or Active Non-Financial Entities (Passive or Active NFEs).

A Passive NFE is an entity whose income is 50% or more derived from passive sources such as rent, royalties, interest, dividends.  If an NFE is not passive, it will be active.

NFEs do not have proactive reporting requirements.  However, when transacting with FIs which involves the creation of a financial account, e.g. opening a bank account, they are likely to be asked to self-certify their AEOI status which will require them to have confirmed what it is.  In addition, a Passive NFE will also have to supply the FI with details of its [the NFE’s] so-called Controlling Persons.A Controlling Person is as defined under the Financial Action Tax Force Recommendations and means the natural persons who exercise control over the entity.

Finally, can I choose to ignore the legislation?

Not really and this is certainly not advisable. Initially FATCA was a U.S. enacted piece of legislation that sought to impose itself on other countries.  Entities with no-US interests could therefore have theoretically ignored FATCA on the basis that its reach would not extend to them.  That time is long past.

Both FATCA and CRS are now part of domestic Australia legislation and indeed part of the domestic legislation of most other countries in which a global group might typically be resident.  Failure to supply the information or the supply of incomplete information can lead to penalties.  There is also a commercial angle to this where FIs are increasingly refusing to transact with FI customers that cannot show that they are compliant with FATCA & CRS. 

Tax authorities are investing in sophisticated technology to interrogate large data sets and elicit ‘interesting’ information.  In that respect, it should be remembered that this is ‘information exchange’ i.e. the HMRC will be receiving a significant volume of information from tax authorities overseas on its own residents as well as transmitting information to third party countries.

If they have not already done so, FIs therefore need to start taking action now as the legislation is already in force and the reporting deadline is approaching fast.