Back to Basics: FATCA and UK trusts

Open any current legal journal, and you’ll almost certainly find mention of the USA’s Foreign Account Tax Compliance Act – pretty much universally known as FATCA. However, it can be difficult working out what FATCA actually means, what it will apply to and what action needs to be taken.

In this Back to Basics, I explain what FATCA is; what it applies to, with special reference to UK trusts; the reporting process; and next steps for UK private client practitioners and advisers.

What is FATCA?

FATCA originated in the USA, as part of the Hiring Incentives to Restore Employment (or HIRE) Act of 2010. The original aim of FATCA was to combat tax evasion by US taxpayers using foreign accounts. It contained provisions on withholding taxes, and requiring financial institutions outside the US to pass information about their US customers to the US tax authorities, the Internal Revenue Services (IRS). Failure to meet these new reporting obligations would result in a 30% withholding tax on the financial institutions’ US-source income.

How has it been brought into UK law?

The UK, along with France, Germany, Italy and Spain, and with the support of the European Commission, then took part in joint discussions with the US government to explore an intergovernmental approach to FATCA. The stated intention was to combat tax evasion generally, not just by US citizens. A model intergovernmental agreement (IGA) was developed, and published in July 2012. On 12 September 2012, the UK and the US then signed an IGA, called the ‘UK-US Agreement to Improve International Tax Compliance and to Implement FATCA’.

The idea of a law firm having to register under FATCA and provide information about its clients, simply because it has their funds in a client account, is worrying

Part of the rationale for the IGA was to reduce some of the administrative burden of complying with the original US regulations. There were also data protection issues, in that UK laws prevented financial institutions from transferring data about customers to the US authorities. The IGA provides a mechanism for UK financial institutions to comply with their FATCA obligations without breaching data protection laws. Under the IGA, financial institutions pass information to HM Revenue and Customs (HMRC), which will then automatically exchange this information with the IRS.

The IGA should also mean that no UK financial institution suffers the 30% withholding tax on US-source income, unless it fails to meet the requirements set out in the IGA and UK legislation.

The IGA was brought into UK law by section 222 of the Finance Act 2013. This was then followed by the International Tax Compliance (USA) Regulations 2013, which came into force on 1 September 2013. HMRC issued guidance notes on these regulations, called ‘The Implementation of The International Tax Compliance (United States of America) Regulations 2013’. These were initially published on 14 August 2013, and then updated on 28 February 2014. The guidance notes are available on the HMRC website (www.hmrc.gov.uk/fatca), and are due to be updated every six months. The next update is expected in August 2014.

Could FATCA apply to other countries?

While FATCA originated in the US, it is no longer just a US issue. Now that FATCA reporting is part of the UK’s laws, it seems highly likely that the UK could enter into IGAs with other countries to pass on information collected under FATCA.

The OECD Common Reporting Standards are expected shortly, and a fourth EU anti-money laundering directive is also being proposed. This may well mean that more FATCA-type agreements are coming, and solicitors dealing with trusts are going to have to provide information to HMRC to be exchanged with tax authorities from around the world. Certainly, the US is not alone in suspecting some of its taxpayers are not paying their due share of tax.

So, while FATCA may be aimed at finding US connections today, there is nothing to stop it applying to other jurisdictions in the future.

What does FATCA apply to?

The UK’s FATCA rules apply to “financial institutions” located in the UK, as well as other UK “entities”, which will need to certify their “classification” for FATCA purposes. Unfortunately, the concept of “entity” is very wide and can include UK resident trusts, as explained further below.

Under the IGA, entities are regarded as “United Kingdom financial institutions” (UKFIs) for the purposes of FATCA, if they are any of the following:

• “custodial institution”;
• “investment entity”;
• “specified insurance company”; and
• “holding companies and treasury centres of financial groups”.

Each category of financial institution is determined by set criteria. Where an entity does not meet the definition of a financial institution, the entity will be regarded as a “non-financial foreign entity” (NFFE). The term “non-financial entity” (NFE) is also used, although the HMRC guidance still refers to NFFEs.

All UK financial institutions must apply the UK regulations in force at the time, with reference to the published HMRC guidance. Provided a UK financial institution does so, it cannot be subject to any withholding tax on US-source income.

A financial institution is only governed by the UK FATCA rules if it is UK-resident, or is a UK branch of a non-UK financial institution. The test follows tax residence, so will include both companies incorporated in the UK and those whose management and control is exercised here. Dual-resident entities will also be within the scope of the UK FATCA rules, and the US ‘check the box’ system (which permits the taxpayer to elect how the entity is taxed) is not relevant for FATCA purposes.

Unfortunately, the HMRC guidance notes on tax residence of trusts are slightly misleading. Where all the trustees are UK-resident, it is clear that the trust is itself UK-tax-resident (and therefore potentially caught by FATCA). However, where the trust has mixed-resident trustees, the test in sections 475-6 of the Income Tax Act 2007 looks at whether the settlor was UK-resident or UK-domiciled at the time the trust was created.

HMRC’s guidance notes, on the other hand, state: “For Trusts, if all the trustees are resident in the UK for tax purposes then the Trust is UK resident. Where some of the trustees, but not all are UK tax resident, then the Trust is to be treated as UK resident if the settlor is both resident and domiciled in the UK for tax purposes.” Note in the last sentence that the guidance says that the settlor must be both resident and domiciled in the UK for tax purposes, rather than one or the other, as per the test in the Income Tax Act 2007. It is assumed that this is more likely to be a typing error.

Which entities are exempt?

Generally, non-reporting UK financial institutions are exempt from FATCA reporting. Such entities do not need to obtain a “global intermediary identification number” (GIIN), and have no reporting obligations nor any additional FATCA due diligence.

There are four types of Non-Reporting UK Financial Institution, as follows:

• “deemed compliant financial institution”;
• “owner documented financial institution”;
• “exempt beneficial owner”; and
• “excepted financial institution”.

All other UK financial institutions must report under FATCA, including obtaining a GIIN, and will have to meet additional due diligence requirements. See below for the relevant deadlines.

White FATCA originated in the US, it is no longer just a US issue. Now that FATA reporting is part of the UK’s laws, it seems highly likely that the UK could enter into IGAs with other countries

Even those entities that do not meet the definition of a financial institution, and are therefore regarded as NFFEs, must ascertain if they are “active” or “passive” NFFEs. An active NFFE (among other definitions) has less than 50% of its income from a “passive source”, and less than 50% of its assets produce passive income. Passive income is defined as: interest; rents and royalties; annuities; and / or property gains.

So, an entity that invests solely in property, producing rent or property gains, is likely to be a passive NFFE. It will not have to report under FATCA, but must confirm that it is a passive NFFE to any financial institutions it may deal with.

Are solicitors within the scope of FATCA?

Since FATCA applies to “depository institutions”, does this mean that professional firms with client accounts are within the scope of FATCA? The idea of a law firm having to register under FATCA and provide information about its clients, simply because it has their funds in a client account, is rather worrying.

Fortunately, this should not be the case. A depository institution is defined as an institution that “accepts deposits in the ordinary course of a banking or similar business”.

For the purposes of the IGA, HMRC will consider whether the UK entity is carrying on a regulated activity for the purposes of the Financial Services and Markets Act 2000. Article 5 of that act contains exclusions, including solicitors. So, while HMRC will review the actual activities that the entity is conducting to see whether these amount to banking or a similar business, it will be unlikely that professional firms will be caught by FATCA just because of their client accounts.

Why are trusts within FATCA?

Perhaps the most controversial part of FATCA is whether, or why, it applies to trusts.

Certain trusts are specifically exempted, such as registered charities (which are deemed compliant financial institutions) and registered pension funds (which are exempt beneficial owners). However, HMRC’s guidance notes make it clear that other trusts are “financial entities”, potentially within the scope of FATCA.

The Society of Trust and Estate Practitioners (STEP) guidance note, FATCA – a Guidance to Member,s states:

“All trusts are caught by FATCA irrespective of whether or not they have: US persons as settlors, trustees or US beneficiaries; or US assets.”

(The guidance was issued in conjunction with the Law Society and Institute of Chartered Accountants in England and Wales (ICAEW), and is available, along with an accompanying flowchart setting out which trusts are caught by FATCA, from the STEP website: www.step.org.uk/fatca)

Trusts are potentially caught by FATCA due to the IGA definition of “entity”. Paragraph 2.36 of the HMRC guidance notes explains that: “A trust could fall within any of the definitions of Financial Institution depending on the nature of its activities and the assets it holds. It is expected that a trust will be treated as a Financial Institution most commonly where it meets the definition of an Investment Entity.”

“Investment Entity” is defined in 2.28 of the guidance notes. This looks at whether the entity “conducts as a business”, or is managed by an entity that conducts, as a business, certain financial activities or operations.

Unfortunately, the term “managed by” is not defined in the UK regulations or the IGA. There are two possibilities as to the term’s meaning. First, “managed by” could refer to management of the trust itself (as opposed to management of its assets), and only the trustee can be said to conduct that role. So unless the trustees were themselves a “financial institution”, trusts would not normally be caught by FATCA. The second interpretation is that “managed by” in this context can include the management of a trust’s assets, such as by a discretionary fund manager. This would mean that any trust with assets invested with a professional fund manager would be within the scope of FATCA. This is the interpretation contained in the HMRC guidance notes, which explain at 2.36:

“With regard to Trusts this means that to be a Financial Institution the Trust must be professionally managed (this would typically be where the trustees have appointed a discretionary fund manager to manage the trust’s assets).

If it is not professionally managed then the Trust will be treated as an NFFE rather than a Financial Institution.

So, a trust will be an Investment Entity and therefore a Financial Institution where:

• the Trustee is a Financial Institution;
• the Trustee (on behalf of the Trust) engages a Financial Institution to manage the Trust; or
• the Trustee (on behalf of the Trust) engages a Financial Institution to manage the Financial Assets for the Trust.”

While some practitioners have queried whether this third bullet point is correct, recent discussions with HMRC suggest that this interpretation is unlikely to change. It is certainly safer to accept that trusts are within the scope of FATCA.

This means that anyone dealing with trusts, whether as trustee or professional adviser, needs to identify which trusts have to report under FATCA.

Which trusts have FATCA reporting obligations?

The flowchart accompanying the joint STEP, Law Society and ICAEW guidance sets out five questions that should be posed with respect to each trust, to define whether it has FATCA reporting obligations. These are outlined below, with further explanation.

1. Is the trust UK-resident? Only UK-resident trusts are within the scope of the UK IGA. A non-resident trust will need to check its own FATCA reporting obligations locally, whether under the original US regulations or under a different IGA.
2. Is it a charity trust? Registered charities are excluded and do not need to register or report.
3. Is the trust acting for customers and is more than 50% of the trust’s gross income attributable to trading in money market instruments, portfolio management or the investment and administration of funds? This is probably unlikely for the vast majority of private client trusts, but if the answer is yes, the trust would be a financial institution.
4. Is the trust managed by an entity which acts for customers and where more than 50% of gross income is attributable to trading in money market investments, portfolio management or the investment and administration of funds? If the answer is yes, the trust would be a financial institution.
5. Is more than 50% of the trust’s income attributable to investing or trading in financial assets? Further: does a financial institution manage the trust or its assets? If the answer to either the ‘main’ or follow-on question is no, the trust is an NFFE.

It is this last category that is most likely to catch the average family trust, which has a portfolio with a professional investment manager. Where at least half of the trust’s income derives from that portfolio, it is likely to be a “financial institution” with reporting obligations under FATCA. It has to be stressed that the FATCA reporting obligations arise irrespective of whether the trust in question has any connection to the US.

So how does FATCA apply to common types of private client trusts? The following practical examples provide guidance.

Pilot trusts

These are unlikely to be caught, as no income is being produced (at least not while the trust deed is sitting in the solicitors’ storage system with a £10 note attached). Such trusts are likely to be NFFEs, and will not need to register or report under FATCA.

Nil-rate band will trusts

The crucial question here will be what assets have been used to create the nil-rate band trust when the testator died. If the nil-rate trust has been created with part of the value of the family home, or a debt / charge over the home, then the trust is likely to be an NFFE and will not need to register or report under FATCA.

If cash has been settled into the nil-rate trust, but the cash is being held in a bank account, then no reporting is required. However, if the cash has been invested with a professional fund manager, then the trust may well be an investment entity, caught by FATCA reporting.

Trusts of land

Co-ownership of land (whether as joint tenants or tenants in common) is a trust of land. However, the property is not usually income-producing, as the co-owners occupy the land, so the trust will again be an NFFE and outside the scope of FATCA reporting. Even if the property in question is rented out, this is “passive income”. So, as long as at least 50% of the trust’s income comes from the land (as opposed to financial investments), then the trust will be a passive NFFE.

Trusts for children

A will trust may have been set up, contingent on a child reaching a certain age (usually 18 or 25). Again, the question will be what the trust funds have been invested in. If the legacy is relatively small, it may have been deposited with a UK bank or held in another exempt investment, such as national savings or premium bonds, in which case the trust will be an NFFE and has no obligation to report under FATCA. However, if the legacy is large enough to have been invested with a professional investment manager, then FATCA will be relevant.

Family trust with funds invested with a discretionary fund manager

This is the most likely scenario where FATCA will apply to a private client trust. Where a fund manager (which is a financial institution for FATCA purposes) has been appointed to invest the trust assets, then the trust is itself a financial institution. The trustees then have to decide how to comply with their FATCA reporting requirements.

What are the FATCA reporting obligations?

Once it has been ascertained that a trust is caught by FATCA, the next question is what reporting is required and by whom.

There is a distinction between trusts with corporate trustees, and those with individual trustees. Corporate trustees have to register and report to FATCA, but do not need to register each individual trust of which they are trustee. So a trust company attached to, say, a law firm, should only have to do one FATCA report for all its trusts. Each trust covered by that one report is known as a “trustee documented trust”. Firms with trust corporations should find it easier dealing with FATCA, so many law firms may well be considering setting up a trust corporation, rather than letting each individual partner be a trustee. (The Law Society is currently working on a practice note on trust corporations. Look out for more details in the Private Client Section newsletter.)

On the other hand, where the trustees are individuals, then each trust has to separately be registered and reported under FATCA. There are various options, outlined below.

First, if the trustees are satisfied that all “owners” (that is, beneficiaries who receive one or more distributions) are not US persons, then the trust can be an “owner documented financial institution”. Such a trust does not need to register or report, but must appoint a “designated withholding agent”.

Second, it is possible for the trustees to appoint a third party to “sponsor” the trust and deal with all reporting issues. The sponsor must register the trust. The trust would then be defined as a “sponsored investment entity”.

Third, but only if 20 or fewer individuals ‘own’ all the interest (which may be difficult to show for a discretionary trust where the beneficiaries include future generations), the trust could appoint a sponsor, and become a “sponsored closely held investment vehicle”. Again, the sponsor must deal with all the FATCA compliance, but does not need to register the trust. Finally, each trust can choose to register under FATCA and do its own reporting.

How easy is it to find a sponsor?

Initially, it appeared likely that finding a sponsoring investment entity to deal with all a trust’s FATCA compliance, would be difficult. When the Law Society, STEP and the ICAEW were first in discussions on their joint guidance, reports were received that many investment houses were reluctant to undertake FATCA compliance for their clients.

Fortunately, spring 2014 saw many investment houses start writing to their clients to confirm that they will be willing to sponsor trusts that have funds invested with them. The question, of course, is whether this service will be provided free of charge, or whether FATCA compliance will increase the costs of investing with a professional fund manager.

What is the timeline for all this?

Currently, those entities (including trusts) that need to obtain a GIIN must do so before withholding starts on 1 January 2015.

The current view is that the deadline to register any financial institutions with the IRS, to prevent withholding, will be October 2014. However, HMRC has yet to publish the mechanics of reporting (remember that HMRC will collate and then pass the information on to the IRS).

The easiest approach might be to include additional boxes on the trust self-assessment tax return, asking the trustees to certify whether the trust is caught by FATCA and, if it is, who is dealing with the reporting. It must be hoped that FATCA does not introduce yet more separate HMRC forms, with separate filing deadlines, for trustees.

What do I need to do now?

Clearly, any professional dealing with trusts, whether as trustee or adviser, needs to identify which trusts are caught by FATCA and which ones need to register.

Systems also need to be put in place to ensure FATCA is taken into account, including whether this requires any amendment to the firm’s engagement letters, client take-on process, or client identification procedures.

For new clients, setting up FATCA systems may be relatively easy. The harder task will be identifying existing clients and their trusts, which are now within the scope of FATCA, and persuading them they need advice on their FATCA compliance. Put crudely,

will clients be willing to pay for their advisers to review every trust, just to see whether it needs to comply with FATCA? Many clients may wonder whether all this compliance is worthwhile if they have no US source income on which withholding tax might fall. However, it is almost certain that professional fund managers will refuse to deal with non-FATCA-compliant customers, in the same way as they cannot deal with clients who do not comply with money laundering rules.

Conclusion

The irony is that many UK trusts may find themselves within FATCA because of their investment portfolios, yet may have no actual US connections to report. Filing a ‘nil FATCA return’ each year may be a costly or at least time-consuming exercise. However, if professional investment houses are willing to act as sponsors for their trust clients, this will relieve much of the burden.