FATCA 101: What American Investors Need to Know
Many U.S. expats are unaware of how the Foreign Account Tax Compliance Act (FATCA) affects them and their taxes. Enacted in 2010, FATCA requires foreign financial institutions to directly report to the IRS on assets held by Americans or U.S. persons. Complicated with extremely high penalties, FATCA puts the burden of proper tax compliance on Americans who have foreign holdings to self-report. This burden makes compliance with many old and new reporting requirements much more critical than had been the case previously.
In this article, we discuss practical implications of FATCA for Americans living abroad and recommended actions to take to avoid being caught unaware of FATCA rules and the risks of non-compliance.
What is FATCA and How Does it Affect Americans Abroad?
Passed as part of the unrelated jobs legislation known as the HIRE law, FATCA is a broad, complex set of rules designed to increase tax compliance by Americans with financial assets held outside the United States.
The legislation was drawn up primarily as a response to the 2009 UBS offshore banking scandal, which revealed many Americans were maintaining large financial holdings in secret Swiss bank accounts without reporting or paying the U.S. taxes due on those assets.
FATCA created new self-reporting requirements and increased penalties for failure to comply fully with complex reporting rules. Most importantly, the legislation imposes on all foreign financial institutions a vast new legal mandate to determine who among their clients are “U.S. persons” and report directly to the IRS information on those clients’ accounts.
This mandate is backed up by draconian enforcement mechanisms that ensure virtually all non-U.S. financial institutions will comply with FATCA reporting rules. The legislation also ratcheted up penalties imposed when taxpayers fail to fully comply with all the special rules that pertain specifically to non-U.S. financial assets.
For Americans abroad, attention must be paid to new self-reporting requirements on foreign financial assets. Equally important, however, is that U.S. taxpayers must be aware of many long-standing reporting and filing rules that have been widely ignored until FATCA’s passage. Failure to comply with these rules has very rarely been an issue because they were virtually unenforceable. However, with the new FATCA reporting requirements on foreign financial institutions, that has changed.
“Sledgehammer” Enforcement of New Reporting Requirements for Non-U.S. Financial Institutions
The most consequential part of the FATCA legislation is the severe penalties the law imposes on foreign financial institutions that are found to be non-compliant with the mandated reporting on the financial activity of their U.S. clients. Foreign financial institutions not complying with the rigorous reporting requirements are subject to a 30% withholding tax on all U.S.-sourced payments.
It’s important to understand clearly what that implies: any financial institution anywhere in the world not voluntarily complying with FATCA will find that 30% of any U.S.-sourced payment (e.g., stock dividends, maturing principal payments from a U.S. corporate or government bond, etc.) will be withheld.
Because U.S. stocks and bonds are so widely owned globally, virtually all financial institutions everywhere in the world receive substantial U.S.-sourced payments, mostly on behalf of clients who have no connection to the U.S. Allowing 30% of these payments to be withheld will not be an acceptable option. That’s why there was almost universal compliance by the July 1, 2014, deadline for foreign financial institutions to enter into a formal agreement with the IRS to comply with FATCA disclosure requirements.
Details of Foreign Financial Institutions Reporting Requirements
Who must report?
FATCA legislation defines foreign financial institutions extremely broadly and is interpreted to include every conceivable kind of financial institution outside the U.S. This includes banks, brokerage firms, insurance companies, trust companies, retirement plan administrators, mutual fund companies, etc.
No category of institution has yet been exempted (although many are lobbying heavily in Washington to be exempted). Furthermore, non-publicly listed corporations or business entities registered outside the U.S. owned 10% or more by a U.S. person must report on the details of the stake held by the U.S. person(s) meeting that threshold.
On whom is there reporting?
Reporting is mandated on “U.S. persons.” This broad category includes U.S. citizens, U.S. residents, green card holders and trusts controlled by U.S. persons. FATCA rules proposed by the IRS include extensive criteria that banks will have to use to screen all their clients to determine which ones appear to be U.S. persons.
What is FATCA reporting?
Foreign financial institutions are required to report directly to the IRS the name, address and account number of all clients deemed to be a U.S. person. They must also report the highest daily account value in U.S. dollars over the course of the year and inflows and outflows to the account.
What are the tax filer self-reporting requirements? What Forms do I need for FATCA?
Since the 2011 tax year, the new IRS Form 8938 must be filed by all U.S. persons if total foreign financial assets owned exceeds $50,000 on the last day of the tax year or more than $75,000 at any point during the year. For U.S. persons residing outside the U.S., the reporting thresholds are raised to $200,000 and $300,000, respectively.
Form 8938 is in addition to the long-standing Treasury Department FBAR (Foreign Bank and Financial Accounts Report) required for financial assets abroad that exceed $10,000. Form 8621 (regarding passive foreign investment companies, or PFICs) must be filed every year for each separate PFIC investment, whereas previously it was only required to be filed in years that distributions were made from the PFIC investment. The statute of limitations for IRS audits of returns listing foreign-sourced income was extended to six years (previously three years).
New FATCA Penalties for Non-Compliance
Where non-compliance is “non-willful,” failure to file Form 8938 results in a minimum $10,000 penalty but may rise to as much as 40% of the value of the asset or account. This is in addition to the tax and interest due. Non-compliance deemed “willful” may also result in criminal prosecution.
While FATCA did not change the existing penalties resulting from failure to properly report, such as those for the FBAR and Form 8621 (PFIC reporting), FATCA has resulted in a dramatically increased enforcement of these rules, and, therefore, Americans abroad should become familiar with the very significant penalties associated with these and other reporting requirements commonly required of Americans abroad.
Practical Implications of FATCA for Americans Abroad
The most common mistake made by Americans abroad regarding FATCA is to assume that since they have been hiding nothing, the extent of the implications for them is simply that they need to file the one FATCA mandated reporting form (Form 8938). Indeed, for many Americans abroad, this is more or less correct. However, the risk of reacting this way is that it ignores the implications for enforcement of all the old reporting rules that have typically never been enforced and therefore were widely ignored by subject taxpayers.
Many Americans who would not dream of not complying with all applicable tax rules have nevertheless been casually non-compliant. This is because so many rules that existed until the passage of FATCA were very rarely enforced. In the absence of any real threat of enforcement, individuals and even tax professionals had been woefully ignorant of rules such as those regarding FBAR or PFICs. FATCA ended this easy accommodation. Old rules, never before seriously enforced, are now easily and commonly enforced as FATCA is widely implemented.
4 Steps All Americans Abroad Should Take to Abide by FATCA Reporting Rules
Step 1: Have a contingency plan in place for when your local banking institution informs you that, as an American, you need to close your account. Compliance with complex FATCA reporting requirements will be simplified for foreign financial institutions if they can simply certify that they have no U.S. persons as clients. Americans will increasingly be forced to rely only on the largest global banking institutions for local financial transactions and banking services.
Step 2: Take inventory of your non-U.S. assets and identify which ones are subject to FATCA reporting by a foreign institution. Make sure these assets are not passive foreign investment companies (PFICs) or improperly reported foreign trusts. Beware: PFICs are much more common than most realize. They may be lurking among your investments or in your bank accounts in the form of non-U.S. mutual funds without you even knowing it. PFICs are taxed very punitively by the U.S. and require complex annual reporting.
Step 3: Move your investment accounts to U.S. financial institutions (and not just overseas branches of U.S. institutions). This will avoid all the difficulties and uncertainties of FATCA compliance for these assets. Furthermore, tax and FATCA compliance aside, there are overwhelmingly good reasons for Americans abroad to invest through U.S. institutions.
U.S. securities markets, for all their faults, are still by far the most efficient and individual investor-friendly in the world. A thoroughly diversified basket of global assets can be constructed within a plain vanilla U.S. brokerage account far more cost effectively than anywhere else in the world.
Step 4: Build a diversified portfolio with optimal exposure to risk and return as well as currency, given your financial situation and long-term residency plans. Generally, younger investors should be assuming more risk in their investments to maximize long-term returns. The currency denomination of your investments should follow the principal of matching investments and liabilities to prevent large swings in relative currency values from upending your retirement plans or other savings goals.
FATCA dramatically changed the financial and tax environment for Americans abroad. These changes cannot be ignored and have added even more challenges to navigating expat taxes. As a result of FATCA, many old and new rules regarding assets held by Americans outside the United States are enforced to a far greater degree than they ever have been before, because, for the first time, the IRS has easy access to information about these assets.
The good news is that these changes have prompted many Americans abroad to take the steps they should have taken long ago: they’re now learning the reporting requirements and making sure they understand the many good reasons, aside from tax and compliance considerations, to maintain investment accounts in the U.S., no matter where you live abroad or how long you will be there.