From 1 January 2014, Australian banks (amongst other non-United States financial institutions) will be required to comply with significant new obligations under US legislation. The Foreign Account Tax Compliant Act (FATCA) is designed to target tax evasion by US citizens in respect of offshore assets and accounts by imposing disclosure obligations on foreign financial institutions (FFIs) which hold these investments.
How does FATCA work?
FATCA works as an opt-in regime through which FFIs can choose to enter into an agreement with the US Internal Revenue Service (IRS) and become a participating FFI. In doing so, the FFI agrees to comply with certain reporting, due diligence and withholding obligations regarding its US account holders.
Although FATCA does not make this mandatory, there is strong incentive for an FFI to enter into an agreement because if it does not, FATCA imposes a 30% withholding tax on “withholdable payments” from the US source to the FFI, including all payments of interest, dividends and income.
The IRS website provides more information about the effect of FATCA and associated compliance obligations.
How are Australian banks affected by the legislation?
Australian banks fall within the broad definition of FFIs and must comply with the disclosure obligations under the Act or expect to incur the 30% withholding tax on relevant payments from US sources (such as interest and principal). This will impact all Australian banks which have US income-producing investments or receive US source income. For example, if an Australian subsidiary of a US parent company defaults on a loan from an Australian bank, "withholdable payments" from the US parent company under a guarantee to the bank will be captured under the Act.
In addition, Australian banks will be required to withhold 30% on any "passthru payment" it makes to a recalcitrant account holder (that is, a US account holder who fails to provide the required disclosure information) and any "passthru payment" it makes to another FFI unless that FFI meets certain requirements.
FATCA also has the potential to impact Australian banks indirectly. Consider, for example, a syndicate loan which involves two Australian banks and a US borrower — one bank has complied with FATCA, the other is a non-participating FFI. Under FATCA, the US borrower must withhold 30% of payments from the non-participating bank. If there is a gross-up obligation on the borrower for the withholding amount under the terms of the loan, this will deplete the borrower’s cash flow and may impact the borrower’s ability to repay the other FATCA-compliant bank.
How do the changes impact Australian banking practice?
There are several foreseeable changes brought about by FATCA which will impact Australian banking practice.
Banks must be able to identify US account holders
Australian banks will need to implement systems to identify accounts held by US persons or persons with substantial US owners. Some relief has been provided by the proposed FATCA Regulations which include threshold amounts for individual accounts ($50,000) and entity accounts ($250,000) before a FFI will be required to provide information to the IRS. In addition, there are different procedures for accounts pre-existing the FATCA commencement date and those subsequently established.
FATCA requires FFIs to look for US indicia in respect of their accounts — such information may not currently be captured through Australian anti-money laundering checks. Australian banks will have to carefully review their Know Your Customer (KYC) procedures to ensure compliance.
Banks must ensure disclosure to the IRS does not conflict with domestic laws
Disclosure obligations required by FATCA may potentially conflict with Australian privacy and confidentiality laws. FATCA requires Australian banks to provide detailed information to the IRS about US account holders including personal identification details, account values and gross receipts and withdrawal. Australian banks will need to obtain the US account holder’s consent in order to avoid breaching state and federal privacy legislation, the National Privacy Principles and the bank’s duty of confidentiality.
The good news for Australian banks is that there may be an alternative means of complying with FATCA. The UK has recently entered into an intergovernmental agreement (IGA) with the US which allows FFIs to report the information required under FATCA to their own regulators, rather than directly to the IRS. This approach is likely to reduce compliance costs, streamline reporting obligations and overcome privacy concerns — particularly because most loan documents currently contain carve-outs from confidentiality provisions where information is required by (domestic) law.
The Australian Government has commenced formal discussions with the US for an IGA.
Banks must consider risk allocation
Australian banks should consider who will bear the potential risk of FATCA withholding tax in legal documents. A FATCA gross-up clause would shift this burden to the borrower. However, as illustrated by the syndicate loan scenario above, there are other factors for Australian banks to consider. What if an agent bank refuses to sign an agreement with the IRS? What if a borrower wants to incorporate restrictions on transfers to non-participating banks in the documentation? What protections should senior banks seek in dealing with subordinated lenders?
Global markets have taken different approaches to these issues. The US loan market believes the lender is in the best position to avoid the tax and has incorporated a FATCA carve-out to the general gross-up provision in documents. This means a borrower is not required to pay additional amounts to a bank if the FATCA tax is required to be withheld. In contrast, the UK market seems inclined to allocate this risk to the borrower. The Loan Market Association based in London recently released specific FATCA riders to be used in its facility agreements for both risk allocation scenarios.
In any case, it seems likely that facility agreements will be amended to include representations and warranties which are aimed at providing protection against FATCA withholding tax arising at all (for example, representations that the borrower is not a resident of the US, none of the obligors are FFIs and that payments under the loan documents are not US source payments).
What should Australian banks do to prepare for FATCA?
Australian banks should start considering the range of commercial and practical issues which will affect their banking business once the legislation takes effect. In particular, banks should:
confirm whether their KYC procedures are capable of identifying US indicia and their internal systems are able to monitor the various disclosure thresholds provided for in the FATCA Regulations;
ensure they will obtain the consent of US account holders before disclosing information which might contravene domestic privacy and confidentiality laws; and
consider revising future loan documentation to address risk allocation issues posed by the introduction of FATCA.
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