When the U.S. Department of the Treasury ("Treasury") and Internal Revenue Service ("IRS") issued proposed regulations relating to the Foreign Account Tax Compliance Act ("FATCA") earlier this year,1 there was a sense that the financial services industry in Asia could finally begin to untangle the knot of FATCA's obligations. However, a review of comment letters submitted by Asian trade groups to the IRS suggests that compliance remains a challenge without further revision of FATCA.
Issues in Asia Generally
The comment letters came from a variety of Asian jurisdictions, including Hong Kong, Singapore, Japan and Australia. While these jurisdictions each face unique obstacles with FATCA compliance, many comment letters shared a general unease with FATCA's scope, as well as skepticism that FATCA's rewards (an estimated US$1 billion in additional tax revenue annually) justified its expenses.2 Generally, FATCA attempts to combat U.S. tax evasion by requiring that non-U.S. financial institutions report the identities of U.S. shareholders or clients — or face a 30% withholding tax on their U.S. source income. But comment letters from higher tax jurisdictions in Asia questioned whether U.S. tax evaders would cheat on their U.S. taxes only to pay local taxes elsewhere.3 Comment letters from both higher and lower tax jurisdictions noted that U.S. taxpayers made up a tiny percentage of total accounts, further complicating the search.4
Some comment letters suggested that cultural differences in Asia needed to be considered. In certain situations, FATCA requires that financial institutions ask a customer who was born in the United States to submit documents explaining why the customer abandoned U.S. citizenship or did not obtain it at birth. The Japan Securities Dealer Association ("JSDA") notes that "asking such a delicate and private question is not something Japanese financial institutions could ask to their customers" and requested "IRS understanding [...] that the general perception relating to nationalities in Japan differs from the situation in the U.S. and/or Europe."5 Even apparently straight-forward requirements may pose challenges in Asia: FATCA requires that customers make representations about their identities "under penalty of perjury" in certain situations. But, as the JSDA notes, Japan has no custom of making legal oaths, so Japanese customers will be extremely reluctant to give them.
Even where cultural differences were not noted, concerns about privacy abounded. FATCA requires that financial institutions report to the IRS certain information about U.S. persons. In some jurisdictions, like Hong Kong, many funds and insurance companies are permitted to disclose information with client consent. But the organizational documents for these institutions might not include these provisions, and the process to change them is not easy. In other cases, such as in Japan or for Hong Kong's mandatory provident plans (i.e., retirement funds), such disclosure is prohibited without further changes to domestic law.6 Proposed legislation in Singapore could ultimately have the same effect.7
"Deemed Compliance" in Asia
FATCA contains partial exemptions (i.e., "deemed compliance") for certain financial institutions that are less likely to be used by U.S. tax evaders. Based on the feedback in the Asian comment letters, these exemptions have limited utility in Asia. For example, the proposed regulations include an exemption for retirement funds. But comment letters indicated that many local retirement plans in Japan and Hong Kong would not qualify for this exemption. The JSDA Comment Letter suggested that this category be revised to offer deemed compliance to any investment vehicle sanctioned under domestic law for "employee wealth accumulation." The Hong Kong Joint Comment Letter offered a similar suggestion: that any government-mandated plan be deemed compliant on the basis that local governments are better positioned than the IRS to determine what types of plans are adequate for the local retirement market.
The proposed regulations also partially exempt "restricted funds" — funds that prohibit investment by U.S. persons. Although many non-U.S. funds have long restricted investment by U.S. persons because of the U.S. federal securities laws, the comment letters suggest that this exemption is less useful than it first appears. Both the JSDA Comment Letter and the Hong Kong Joint Comment Letter pointed out the exemption also requires that funds be sold exclusively to limited categories of FATCA-compliant or exempt institutions and distributors. These categories are themselves difficult for Asian institutions to comply with. For example, a restricted fund may sell to certain distributors who agree not to sell to U.S. persons ("restricted distributors").8 But restricted distributors must operate solely in the country of their incorporation, a true obstacle in smaller markets such as Hong Kong and Singapore where many distributors must operate regionally to attain scale. In order to make the exemption viable, comment letters suggested that restricted distributors instead be permitted to operate regionally in Asia.9 Other permitted distribution channels for restricted funds are "local banks," which are not allowed to have any operations outside of their jurisdiction of incorporation and may not advertise the availability of U.S. dollar denominated investments.10 But investors in Hong Kong routinely make U.S. dollar investments; Hong Kong's currency is pegged to the U.S. dollar and over 90% of funds are either denominated in U.S. dollars or have U.S. dollar share classes. The Hong Kong Joint Comment Letter suggests that this requirement must be removed for the exemption to be workable.
When No Exemption Applies – Challenges in FATCA Compliance in Asia
Because of the challenges of applying the "deemed compliance" categories in Asia, many financial institutions must now consider what steps to take to prepare for FATCA compliance. Comment letters identified issues with the following FATCA requirements: (1) account due diligence; (2) closure of non-compliant "recalcitrant" customer accounts; and (3) withholding against recalcitrant accounts and non-compliant financial institutions.
The core of FATCA is the process of reviewing customer records to search for "U.S. indicia" — that is, evidence that a customer might be a U.S. taxpayer. While the proposed regulations suggested that financial institutions could rely on their existing anti-money laundering procedures for this requirement, the comment letters noted that this might not always be possible. Under certain circumstances, FATCA requires financial institutions to look through their customers and counterparties' ownership to find "substantial U.S. owners" (generally, certain U.S. persons holding more than 10% of an entity).11 In both Hong Kong and Japan, existing anti-money laundering legislation generally requires that financial institutions look through entities only when there is a 25% owner, leaving a gap between information that may be needed for FATCA compliance and existing procedures.12
Where customers fail to provide requested information to ascertain their U.S. status, FATCA eventually may require closure of their accounts. But in Asia, this mandate bumps into local legal requirements: comment letters from Japan, Singapore and Australia all noted that compulsory redemption was impermissible, impractical or a possible breach of contract. In the case of retirement plans where participation is mandatory, forced redemption would defeat the express purpose of the product.13 In Hong Kong, forced redemption may be allowed in retail funds, if it is expressly permitted in organizational documents. But many funds' organizational documents never contemplated that compulsory redemption would be necessary, so costly shareholder approvals are needed before such funds can become FATCA-compliant.
Local law may also complicate compliance with FATCA's withholding obligations. In some situations, an institution may be required to withhold 30% from payments that have no connection to the United States (e.g., with respect to pass-thru payments). The JSDA Comment Letter openly questioned whether Japanese law would permit such withholding and queried whether it would also violate customers' property rights under Japanese law. In Hong Kong, retirement plan providers face a similar issue. The Mandatory Provident Fund Schemes Ordinance (1995) permits deductions from plans only for certain specified purposes, which do not include FATCA withholding.
The breadth of issues presented by the comment letters suggests that FATCA can be implemented efficiently in Asia only with significant changes to existing local laws or equally significant accommodation from the IRS and Treasury. But the timeline for FATCA compliance remains tight — financial institutions must enter into "foreign financial institution agreements" in 2013. Inter-governmental cooperation may not come soon enough to beat that deadline.
The best approach may be for Asian trade groups to continue their dialogue with the IRS and Treasury, while Asian financial institutions begin to assess their FATCA burdens as they prepare for compliance.
1 Regulations Relating to Information Reporting by Foreign Financial Institutions and Withholding on Certain Payments to Foreign Financial Institutions and Other Foreign Entities (February 8, 2012) ("Proposed Regulations").
2 Joint Committee on Taxation, Publication JCX-6-10, Estimated Revenue Effects Of The Revenue Provisions Contained In An Amendment To The Senate Amendment To The House Amendment To The Senate Amendment To H.R. 2847, The "Hiring Incentives To Restore Employment Act" Scheduled For Consideration By The House Of Representatives On March 4, 2010.
3 Investment Trusts Association, Japan, Comment Letter to the IRS (April 26, 2012).
4 For example, U.S. citizens account for 0.04% of Japan's 127 million residents and less than 0.30% of Hong Kong's residents. Japan Securities Dealers Association, Comment Letter to the IRS (April 30, 2012) ("JSDA Comment Letter"); Hong Kong Federation of Insurers, Hong Kong Investment Funds Association, Hong Kong Trustees' Association, Joint Comment Letter to the IRS (April 30, 2012) ("Hong Kong Joint Comment Letter").
5 JSDA Comment Letter.
6 Hong Kong Joint Comment Letter.
7 Investment Management Association of Singapore, Comment Letter to the IRS (April 30, 2012) ("Singapore Comment Letter").
8 Proposed Regulations Section 1.1471-5(f)(4).
9 Hong Kong Joint Comment Letter; Singapore Comment Letter.
10 Proposed Regulations, Section 1.1471-5(f)(2)(i).
11 Proposed Regulations, Section 1.1473-1(b).
12 JSDA Comment Letter; Hong Kong Joint Comment Letter (the letter notes that Hong Kong anti-money laundering regulations require looking-through to 10% owners in certain high-risk situations).
13 In the case of Hong Kong's mandatory provident funds, employers have an obligation to ensure that employees remain in the program. Hong Kong Joint Comment Letter.
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