While free from the most burdensome consequences of the incoming EU DAC6 intermediary disclosure rules, Swiss and Liechtenstein fiduciaries are not entirely untouched by them. As elaborated in the article I co-authored in Trusts & Trustees on the effects of the OECD Model Disclosure Rules (MDRs) and EU DAC6 on fiduciaries (available here), the broad scope and intrusiveness of the incoming reporting regimes will fundamentally alter the profession for many fiduciaries. Fortunately, for Swiss or Liechtenstein fiduciaries, the full impact is delayed – perhaps indefinitely, though likelier for no more than a few years. Nonetheless, even non-EU fiduciaries must assess the consequences to their current activities under the EU DAC6 protocol.
This blog analyzes the following DAC6 consequences for Swiss- or Liechtenstein-based fiduciaries, notably trustees and Treuhänder:
DAC6 mandates that for certain transactions or scenarios relating generally to OECD CRS or BEPS action item 12, qualifying EU intermediaries must:
While different sets of characteristics determine which transactions or scenarios related to perceived CRS abuses are reportable, core commonalities across the relevant characteristics are an objective standard (“reasonable to conclude”) and the absence of an intent element (“has the effect of”). By draining the standard of subjectivity and motive, the EU DAC6 revokes the Intermediaries’ discretion to distinguish between abusive and non-abusive activities. Furthermore, the scope of qualifying EU intermediaries – capturing anyone “who provides aid, assistance or advice” in connection with the reportable transaction – is vast. As a result, a few relief provisions notwithstanding, trustees and similar fiduciaries must consider the DAC6 reporting implications for almost all cross-border transactions where they play a role…. But only so long as the fiduciary has sufficient jurisdictional nexus with the EU.
In order to be subject to the full extent of the DAC6 disclosure rules, the potential Intermediary must be:
Few Swiss and Liechtenstein trustees will squarely satisfy any of the top three criteria due to their location in jurisdictions that have not yet enacted these laws. There is, however, a risk of implication through membership in a professional association in an EU jurisdiction. This jurisdictional hook is not yet defined though. It does not appear in the OECD MDRs and thus is not further developed in the commentary section of that document. Furthermore, the scope of associations “related to legal, taxation, or consultancy services” could be strictly limited to professional organizations for those specific industries or more broadly refer to any businesses with these services as conspicuous components. For certain Swiss or Liechtenstein trustees, the extent may be determinative. Under a broad interpretation, membership in an EU-based fiduciary association, like STEP UK, might compel them to test all their actions for reportability under DAC6, even in the absence of any other EU nexus.
Otherwise, most Swiss or Liechtenstein trustees will never fall under the DAC6 reporting requirements without a point of contact generated by their EU operations. For Swiss or Liechtenstein trustees and Treuhänder, typically, that point of contact will be a lower-tier company or partnership out of a jurisdiction like Luxembourg. However, the contact point could range from Cypriot, Maltese or Scottish trusts to Dutch Anstalts to Italian Fiduciaria to Maltese or Scottish partnerships to any other component of a private wealth management structure set up in an EU jurisdiction. If the Swiss or Liechtenstein trustee oversees such EU operations, it must scrutinize any cross-border transactions involving these EU operations for the DAC6 reporting implications. Such direct application of DAC6 is the most burdensome scenario Swiss or Liechtenstein trustees might face, but not the only one.
Even Swiss and Liechtenstein trustees with purely local or non-EU operations cannot completely escape the pull of the DAC6 disclosure rules because of the residual reporting responsibility for taxpayers. As explained above, DAC6 imposes its reporting obligations primarily on Intermediaries, rather than their clients. However, the clients – if EU resident themselves – may incur a residual reporting duty. This duty attaches to the EU client if the transaction is reportable, but there is no Intermediary obligated to report it. One clear example of such a scenario is where legal professional privilege prohibits the Intermediary from disclosing client information and thus relieves the Intermediary of a DAC6 reporting responsibility. There are others though, namely, where the Intermediaries are located in non-EU jurisdiction and lack any point of contact with the DAC6 regime. In such situations, any EU client(s) connected to the reportable transaction are themselves on the hook for reporting it.
An illustrative example may be useful.
As the above scenario will be common enough for many Swiss or Liechtenstein trustees to encounter, they must think through the implications. The first question must be whether the fiduciary duty of the trustee towards the beneficiary imposes a legal obligation of some sort on the trustee? I think, very likely not. To my knowledge, no legal precedent compels a fiduciary to undertake such reporting on behalf of the client where the responsibility falls directly on the client, rather than on the client’s structure (though I am no expert on fiduciary law and its interpretations). Further, the regime itself envisions a method for clients to report without Intermediary support and provides no means for Intermediaries reporting outside of their own jurisdictions. As such, it seems that DAC6 neither mandates nor allows for the Swiss trustee to report on behalf of the EU beneficiary.
However, the inquiry for most Swiss and Liechtenstein fiduciaries will not end with the extent of their legal duties. While most clients may accept that bankers offer a narrow set of banking-related services and offer little beyond the terms and conditions of the account opening contract, they rightly expect fiduciaries to do more. In fact, a broad commitment to the client’s interests is a prime element of many trustee’s overall offering package. As such, if the local tax authority were to demand an explanation from our EU beneficiary for any neglect of his or her DAC6 residual reporting duty, the beneficiary will probably demand his or her own explanation from the Swiss trustee. While this vexation with the Swiss trustee is unlikely to turn into legal action, the client relationship may be irreparably harmed and the trustee’s reputation for client service correspondingly tarnished.
So, what is a conscientious fiduciary to do in this case? Several options spring to mind – none of which is optimal – and are set forth below in order of the fiduciary’s ascending burden:
As Swiss and Liechtenstein fiduciaries contemplate their responses to the EU’s DAC6, they will need to assess their contact points to the disclosure regime, measure the scope of their involvement and determine which – if any – of the above services they might wish to offer any clients who suffer the consequences of residual holding reporting.
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Swiss banks, Fund Managers and Investors: What the §1446(f) Proposed Regulations Demand of Each Party
The §1446(f) Proposed Regulations for the withholding tax due on sales of designated partnership interests spreads the compliance burden across multiple Swiss market participants. Swiss banks, fund managers and investors all incur their own separate - but interrelated - duties under the new regulations released on 7 May. Satisfaction of these obligations necessitates a mixture of updated documentation, new withholding awareness and adjusted reporting processes. The following paragraphs examine the provisions and pitfalls for Swiss banks, fund managers and investors, respectively, due to the §1446(f) Proposed Regulations.
Background to IRC §1446(f) and the §1446(f) Proposed Regulations
Of the numerous substantive provisions contained in the 2017 tax bill, §864(c)(8) stands out by resolving a specific problem with a direct solution. The statutory provision overruled a US Tax Court decision from summer 2017 called Grecian Magnesite. The ruling had challenged the long-standing IRS interpretation that the sale or other disposition of an interest in a partnership that could earn effectively connected income (ECI) likewise qualifies as ECI. The new statutory provision codified the IRS interpretation: The proceeds from sales of such Specified Partnership interests are treated as effectively connected gain or loss and thus taxable by the IRS.
As such, the new provision essentially re-affirmed the substantive status quo. Except that Congress also added a new withholding dimension, imposing on any buyer of an interest subject to §864(c)(8) the obligation to withhold 10% of the gross proceeds paid to any non-US seller. The §1446(f) statutory provision, however, did not explain how that ought to work in practice, least of all for Publicly-traded Partnerships (PTPs), where the buyer and seller are typically invisible to one another. As such, the Treasury Department promptly suspended the withholding regime for PTPs. Shortly thereafter, via Notice 2018-29, the Treasury invoked a pre-existing set of regulations for withholding on US real property income to serve as a temporary bridge until Treasury could conjure an appropriate set of rules for withholding around PTPs, private equity funds and other myriad types of investments captured by the new provisions. The stop-gap rules will remain in effect until the Treasury Department publishes final regulations announcing their expiration dates (see the last section of this blogpost for further elaboration on the timeline for the §1446(f) regulations).
Previously, I addressed the preliminary and subsequent developments of §§ 864(c)(8) and 1446(f) in several blogs (available here) and at the Operational Taxes for Banks, Europe Conference in Zurich last November (available here).
Prior to last month’s release of the Proposed Regulations, however, material doubts remained as to the final rules, their impact on various affected parties and their manner of implementation. As set out below, with several crucial exceptions, those doubts are now settled.
Swiss Banks (see generally, Prop. Regs. §1.1446(f)-4)
Swiss banks will need to renovate their withholding and reporting mechanisms in order to encompass the withholding and reporting required by qualifying brokers on the sale or other disposition of in-scope PTPs by non-US Person investors. A common aim for bank associations in submitting comments to the IRS on 1446(f) was to fold the new PTP withholding regime into the existing Qualified Intermediary (QI) regime. To a large extent, they were successful as the overall structure, documentation and reporting Forms and deposit procedures are lifted from the QI regime.
However, they were not completely successful in achieving this common aim and so, major operational and legal issues will arise. The need to withhold on unpredictable sales proceeds, rather than on stable periodic income flows, will complicate the identification of withholdable payments for banks custodying PTPs. Also, and more dramatically for Swiss banks, the Form 1042-S reporting will oblige them to list sellers on a named, individuated basis - rather than on a pooled and anonymized basis - which will collide with Switzerland’s bank confidentiality laws. Several industry groups (e.g. SIFMA, the Swiss Bankers Association) submitted comment letters to the IRS explaining the fallibility of the approach as set forth in the Proposed Regulations. It is scant exaggeration to assert that the on-going viability of the PTP market in Switzerland depends on the malleability of these provisions.
Swiss Investors (see generally, Prop. Regs. §§ 1.1446(f)-1, -2)
Swiss investors will face a double-edged sword that cuts at them coming and going. When they buy a Specified Partnership interest, the obligation to withhold and report on the gross amount of sales proceeds applies. When the Swiss investors sell the same or any other Specified Partnership interest, they will need to understand the exceptions to withholding and/or the mechanics of claiming a credit for the amount withheld under 1446(f). The foremost goal for affected Swiss investors is to ensure that they are not taxed needlessly or twice under the regime. The outstanding challenge will be to calculate the correct amount of tax due per the §864(c)(8) regulations and then to navigate the multiple forms and operational pitfalls in their path to preventing inappropriate withholding and/or claiming appropriate tax credits.
Swiss Fund Managers (see generally, Prop. Regs. §§ 1.1446(f)-2, -3)
Swiss fund managers will have limited foreground duties. They need to prepare for back-stop withholding in case the buyer neglects the primary duty and to conduct primary withholding duty in the limited circumstance that a distribution from the fund is treated as sales proceeds. On the other hand, their background duties will be considerable.
The other parties mentioned above will request certain information from their fund managers and that information must be provided in the timeframe and format mandated by the IRS. Accordingly, fund managers must become fluent in a variety of official IRS Forms and unofficial notifications, statements and certifications and their correct usages. By my count, the Proposed Regulations reference 7 new or amended IRS Forms and 7 new notifications, statements or certifications, each with its own delineated purpose.
More strategically, Swiss fund managers will need to consider how and how much of the burdens imposed on the others, notably their investors, they wish to assume on their behalf. In order to preserve the market for in-scope fund offerings, fund managers may need to disencumber their clients and counterparties at their own expense.
Finally, to the extent Swiss fund managers operate over-the-top blocker corporations on behalf of their clients in Cayman or Luxembourg, these will qualify as non-US Persons for purposes of §1446(f) and be subject to the range of compliance duties set forth in the Swiss Investors’ section above.
Timeline and Action Items
One more aspect of the §1446(f) Proposed Regulations that has drawn scrutiny from commentators is the implementation schedule. As set out above, Swiss banks and fund managers must adjust or invent processes and procedures in order to cope with novel developments under §1446(f). However, rather than grant these financial institutions ample implementation leeway, the §1446(f) Proposed Regulations declare that the new rules will come into effect only 60 days following publication of the Final Regulations in the Federal Register. With the comment period window already shut, affected parties ought to anticipate Final Regulations – and the subsequent activation of this compliance regime in full - in the near term.
This aggressive timeline compels affected parties to initiate their compliance plans in advance of the publication of the Final Regulations. In so doing, they ought to consider the following concrete steps towards readiness:
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On 3 April the US Securities and Exchange Commissions (SEC) clarified the criteria for digital tokens and similar assets to qualify as “securities” under US law through the release of new framework guidance (the “Framework”) by its Strategic Hub for Innovation and Financial Technology (“FinHub”). Once classed as a security, the issuance of these digital assets in an initial coin offering (ICO) is subject to the SEC’s registration requirements. These registration requirements can be unwieldy and expose the issuer to investor lawsuits for any arguably misleading claims. While there are multiple exemptions to the registration requirement, any such exemption must be identified, evaluated and affirmatively adopted. Crucially, this not a new standard, but rather a comprehensive restatement of the current rules as applied to digital assets. Thus, the analysis applies to prior ICOs, which at the time may have been assessed – reasonably but incorrectly – not to qualify as a security offering (which may then require a curing of the initial non-registration).
What is the Framework?
In spite of multiple public announcements on the treatment of ICOs under federal securities law, the Framework is the first piece of written, consolidated guidance from the SEC on the regulation of digital tokens. Curiously, following such considerable wait and anticipation, the guidance is non-binding on the agency. Rather than a regulation or formal statement of the SEC’s position, the Framework is a compilation of existing jurisprudence on the defining characteristics of a “security” and their application to digital assets. Despite such an odd provenance, the Framework provides invaluable details and insights into the SEC’s perception of digital tokens as securities. Coupled with the SEC’S first “no-action” letter in the ICO sphere (see below), released in parallel with the Framework, 3 April marks the date on which the SEC unveiled its views on ICOs to the crypto community.
What does the Framework do?
Beyond the traditional understanding of securities such as stocks and bonds, US federal securities law (the 1933 and 1934 Acts together) includes the category of “investment contracts”. As the Framework acknowledges, the investment contract category is the one the SEC uses to capture “unique or novel instruments or arrangements.” As the term itself is sufficiently vague to be both substantially over- and under-inclusive, US federal courts developed criteria to narrow the scope, while sustaining the core objectives of the securities laws. In the SEC v. W. J. Howey Co. holding of 1946, the US Supreme Court provided a defining set of analytical factors known since as the Howey Test. Per the Howey Test, a financial instrument or arrangement qualifies as an investment contract for purposes of the US federal securities law if there is:
Notably, the Framework asserts that the criteria be assessed on matters beyond the terms and forms of the digital assets themselves. Accordingly, a proper analysis must additionally contemplate the circumstances surrounding the asset, including the “network” (defined as broadly encompassing all elements comprising the digital asset’s network, enterprise, platform or application), its marketing and its sale and potential re-sale. Tested against this broader background, if an investment satisfies all four elements of the Howey Test, then such investment would qualify as an investment contract and thus a security.
The Framework explores each of the four elements, but operates on the assumption that most digital assets squarely satisfy the first two elements – both of which are broadly construed by the SEC, if sometimes less so by US courts. Accordingly the Framework eschews significant investigation into them. Instead, it targets the “reasonable profit expectation” and “efforts of others” factors as the elements ripe for uncertainty and thus in want of further guidance.
In conceptual terms, these two factors - taken together - effectively query whether based on “economic reality” an investor expects to be enriched thanks to someone else’s efforts that are essential to the success of the enterprise. Delving into this concept, the Frameworks sets out a litany of evidentiary factors for issuers of digital tokens to consider, such as the following:
No one factor from the list of evidentiary factors is dispositive and the list itself is not exhaustive. Rather, the more of these evidentiary factors that are met and the more squarely each factor is met, the more likely that a digital token will qualify as a security.
Finally, an initial analysis may be reconsidered if the characteristics of the digital assets evolve. Digital assets that qualify as securities upon issuance may develop or lose characteristics relevant to the Howey Test and permit subsequent re-appraisal as non-securities (and, presumably, vice versa).
What does qualification as a security entail?
Qualification as a security carries an unwelcome burden. Absent an exemption, an issuer of securities must register the security prior to sale by divulging the following required information:
For many token issuers, SEC registration requirements are too steep a price for an ICO and alone could deter the issuer from embarking on one (especially as misstatements in the registration materials may be grounds for private fraud claims against the issuer). Luckily, Regulation D of the Securities Act (“Reg D”) permits unregistered issuances (also called “private placements”) in a variety of scenarios. The eligibility of an issuance for an exemption under Reg D pivots on two primary factors: The total value of securities issued and the types of investors to whom the securities are sold.
What does all of the above mean for an issuer of digital assets?
Generally, the Framework is a positive development for issuers of digital assets as it introduces greater certainty into the analytical process. Despite the odd conditions of the Framework (i.e. not a formal SEC ruling or the like), such a comprehensive exploration of the relevant concepts and legal holdings, further contoured to the ICO sphere, should be regarded as the blueprint for the securities law inquiry prior to an ICO.
In furtherance of these standards, the SEC’S first ICO no-action letter (essentially, a private letter ruling on a securities law matter) hewed to the Framework analysis in declaring that the agency did not regard the pending ICO by TurnKey Jet, Inc. as security issuance. This letter also illuminates how rigidly the SEC will apply the evidentiary factors set forth in the Framework, how the agency will weight certain factors and how the SEC generally views digital assets as securities.
Coupling the Framework with the no-action letter, the SEC’s publications on 3 April 2019 provided the guidance necessary to assess ICOs under the US federal laws. Any party contemplating an ICO ought to determine (a) whether the tokens issued will qualify as a “security” by means of the Framework analysis and, if so, (b) whether an exemption from registration is available, before deciding (c) whether, based on (a) and (b), the ICO remains worthwhile in its present form.
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Over the holiday season, the US Treasury Department released the Proposed Regulations to IRC §864(c)(8), governing the sale, transfer or other disposition of certain partnership interests (mainly, private equity fund investments) by non-resident aliens (NRAs). The Proposed Regulations resolve the inconsistencies between the statute and existing US tax principles by incorporating heaps of existing federal tax provisions by reference. This deference molds the new statute to existing rules covering partnership interest sales by NRAs, but, as a result, this topic demands exhaustive prior exposure to multiple areas of US federal tax law. Alone, Example Three of the illustrative examples at the end of the Proposed Regulations implicates multiple tricky concepts from the partnership rules under subchapter K, such as the scope of §704 allocation discretion, the calculation of outside basis and the recharacterization of sales proceeds per §751, plus various international and corporate tax concepts, such as ECI, USRPIs and sourcing rules. Moreover, these concepts merely serve as the background landscape to the Proposed §864(c)(8) Regulations, which then apply their own special mustard to the topic. In sum, those with a taste for the diverse provisions referenced in this regulatory hot pot, will delight in savoring each one. The rest though may feel quite queasy when a single reference (even one from inside a parenthetical) leads to a hundred pages of extra regulations.
Content of Proposed §864(c)(8) Regulations
For those with the stomach to digest all these background prerequisites, the Proposed Regulations effectively settle many statutory ambiguities attendant to the sale, transfer or other disposition by NRAs of partnership interests earning potential ECI. Foremost, it informs the taxpayer how to calculate the amounts of gain or loss taxable as ECI. First, it instructs the NRA taxpayer to calculate effectively connected gain or loss and to characterize portions of the gain or loss as capital gain or ordinary income under the prevailing principles of subchapter K. Then, it sets forth a three-step process in order to cap this amount: Calculate the amount of gain or loss by means of a hypothetical sale scenario of all the partnership’s assets; determine the portion of such amounts qualifying as ECI; and identify the distributive share of such ECI attributable to the NRA transferor (consistent with §704). These two calculations, heavily reliant on themes from subchapter K, are the essence of the Proposed Regulations.
However, other topics are addressed as well in an effort to ensure that the core aim of taxation of such interests as ECI is reached, but not overreached. In order to accomplish this purpose, the regulations contemplate the following items:
Implications for Swiss Taxpayers, PE Funds and other Swiss Financial Institutions
These Proposed Regulations set out the method of calculation for taxable income from the sale or other disposition of qualifying partnership interests by NRAs. Such information is crucial to NRA taxpayers who must calculate their taxable income following the sale of such an interest. Furthermore, private equity funds ought to rely on these Proposed Regulations in order to determine which information their NRA investors will expect to receive in order to calculate their §864(c)(8) tax liabilities.
But there are other party-goers at this banquet and several corollary topics remain unaddressed, two of which will play significant roles for Swiss private equity funds and financial institution, as follows:
Through the release of the Proposed §864(c)(8) Regulations, the regime governing the sale or other disposition of certain partnership interests by NRAs advances, but it does so fitfully and through resort to daunting preparatory knowledge. The incorporation of so many provisions from other sections of the US tax code and regulations, however, while helping ensure consistent flavor, may deter newcomers from taking a first bite.
Timelines and Other Sources of Information
As Proposed Regulations, these rules are not in force until released in final form. If finalized by 22 June 2019 the §864(c)(8) Regulations will be retroactive to 27 November 2017 (or, if not finalized until after 22 June 2019, to 20 December 2018).
Previously, I addressed §864(c)(8), along with §1446(f)’s associated withholding rules, in several blogs (http://millentaxandlegal.ch/blogs.html) and at the Operational Taxes for Banks, Europe Conference in Zurich last November (http://millentaxandlegal.ch/speaking-engagements.html). In the latter case, however, I concentrated on the treatment of PTP interests, as the audience consisted primarily of bankers, rather than investors or fund managers.
Here's the good news: The IRS referenced well-known regulations in order to implement the new withholding provision applicable to dispositions of certain partnership interests.
Here’s the bad news: Those well-known regulations are the not very well-loved FIRPTA regulations for withholding on dispositions of US real property interests.
This blog will set out and review the following related matters:
Background to §§ 864(c)(8) and 1446(f)
Amongst the strategic transformations and pork barrel addenda that collectively define the 2017 tax bill, the US Congress enacted one provision, §864(c)(8) that stood out in by squarely addressing a specific problem with a mainly uncontroversial solution (see my earlier review of the new provision). In summary, the provision overruled a Tax Court decision from last summer called Grecian Magnesite. The ruling had challenged the IRS interpretation that the sale or other disposition of an interest in partnership that could earn effectively connected income (ECI) likewise qualifies as ECI. The new statutory provision codified the IRS interpretation.
In addition to affirming the IRS position, Congress added a new withholding dimension, §1446(f), obliging the buyer of an interest (referred to as the “transferee”) to withhold 10% (a seemingly arbitrary percentage) of the acquisition price from any non-US seller (referred to as the “transferor”). The amount realized is calculated via a deemed sale hypothetical - i.e. as if the partnership had sold all its assets at current FMV - in order to determine the amount, if any, of ECI it would have earned. If such withholding is not conducted by the transferee/buyer at the time of the acquisition, then the fund itself must withhold on subsequent distributions to the transferee/buyer.
The Practical Issues Arising from the Statutory Text
The statutory provisions settled the theoretical question posed by Grecian Magnesite, while generating a host of practical ones. Primarily these practical questions concern the exceptions to the withholding requirement and the determinants of the amount to be withheld, such as the following:
Release of Notice 2018-29
The absence of any guidance on such fundamental operational matters helped persuade the US Treasury Department to swiftly suspend the application of the new withholding rules to the sale of publicly-traded partnership (PTP) interests at the end of December 2017, while inviting comments on other similarly-affected transactions. This uncertainty for the sale of non-PTP interests lingered until April, when the IRS released Notice 2018-29, addressing - in full or in part - the key questions emerging from the new statute (see list above) and inviting taxpayers to rely on the Notice until formal regulations could be prepared, proposed and published. By referencing the FIRPTA regulations as the source for guidance, supplemented by a few additions specific to the text of §864(c)(8), the IRS erected a short-term bridge across the holes in the statute.
Further, the Notice suspended the operation of the residual withholding obligations imposed on the funds themselves to withhold on subsequent distributions to any transferee/buyer that neglected to apply the 10% withholding at the time of the transaction. Finally, it waived the application of interest and penalties for any deposits due but not made prior to 31 May (tolling them until 31 May).
Despite the significant color daubed on the withholding picture by the Notice, several big questions remain outstanding. The most seismic is the treatment of PTPs. In a comment letter from SIFMA (the “voice of the [US] securities industry”) dated 2 August 2018, SIFMA outlined the impracticability of the FIRPTA-based approach to PTPs due to the current set-up for holding PTP interests, namely, the non-visibility of the relevant parties to one another. As an alternative, SIFMA proposes a system similar to the Qualified Intermediary (QI) regime for US publicly traded equities which imposes the withholding obligation on the client-facing custodian of the PTP interests, and relief for funds from any residual withholding responsibility.
A second consideration overlooked by the Notice is the impact of the withholding regime on non-US flow-through entities with US partners/owners. This omission most notably implicates US partners in non-US funds of funds with investments through multiple tiers that ultimately yield ECI. Under international and flow-through taxation principles, such US partners are not subject to ECI taxation. Accordingly, the possibility ought to avail for the non-US partnership to provide a certification and underlying documentation that correspondingly reduces the withholding due on the disposition of lower tier partnership interests. For chapter 3 (QI) purposes, the Form W-8IMY and accompanying withholding statement collectively serve this objective. Therefore, the solution is at hand, even if not yet formally blessed by the IRS.
While more of a niche topic for non-PTP interests, doubts prevail concerning the correct treatment for the lending of partnership interests under §1058. Presumably, the general understanding for securities lending - that it does not constitute a sale or other disposition of the asset - applies to partnership interests with respect to §864(c)(8). However, the absence of any express expansion of the §1058 standard to the lending of partnership interests may distort or deter the sec lending market.
The single most outstanding question is, of course, whether the final regulations dedicated to withholding under §1446(f) will continue in this FIRPTA vein or swerve in another direction. While it would be unlikely (and ferociously vexing) for the IRS to compel the affected parties to adopt and implement a temporary withholding regime based on FIRPTA and then abandon it in favour of something else entirely for the permanent one, it is not inconceivable.
Considerations for Affected Swiss Parties
Swiss-based parties involved in US-based private equity investments may be impacted by the new rules in myriad ways depending on their specific role in such investment. Each role entails its own areas of concern, as follows:
In the end, the reliance on FIRPTA principles is as useful in Switzerland as elsewhere: Potentially beneficial, but mainly for those affected parties that have some experience with them. For the rest, the Notice introduced a new set of challenging regulations that will need time, resources and patience to master.
For all the sound and fury, Sturm und Drang, massive expenditure and general anxiety about its implementation, one peculiar element of FATCA has been the near total absence of enforcement by the IRS or other authorities. Predictions that FATCA reports would be compared instantly with FBAR submissions, discrepancies identified automatically and inquiry letters dispatched forthwith, have not been fulfilled. Instead, the IRS seemed content to deputize the major custodial banks and other large Financial Institutions (FIs) through the dual threat of withholding and the Responsible Officer (RO) Certification requirement and then to rely upon them to ensure that everyone else obeyed. As of today, I have seen a single story of a FATCA violation resulting in an enforcement action and, in that case, the FATCA violation seemed a pretext for prosecuting a securities fraud unrelated to FATCA entirely.
That may be about to change...
On 9 July, the Treasury Inspector General for Tax Administration (TIGTA) published an audit report, castigating the IRS for its lenient enforcement of FATCA. This report highlighted the massive outlay by the US fisc for FATCA implementation (Note: This eye-popping sum of USD 380M omits the multiples of it spent by non-US FIs on FATCA activities). Despite this sum TIGTA contended, the IRS had failed to implement its own blueprint for enforcement. While the criticisms and recommendations had several shades, the main thrust was that the IRS does not adequately ensure the collection of bona fide Taxpayer Identification Numbers (TINs). Accordingly, the IRS struggles to conduct reconciliation and crosschecking across Forms submitted by other parties to a transaction, a critical step for the identification of non-compliance by US taxpayers and withholding agents.
Generally, the IRS did not contest the report’s main claim that it needed to improve TIN collection and exploit the information to stiffen enforcement mechanisms. Specifically, the TIGTA report issued six recommended modifications, four of which the IRS agreed to adopt. Notably, one it rejected (to the chagrin of TIGTA) was the validation of all TINs collected. Instead, the IRS countered that the TIGTA recommendation to improve certain automated processes, which it had accepted, would also encompass this activity (which seems correct to me only if you squint very hard at it).
In any case, the IRS will need to show more FATCA enforcement return on its investment in order to allay internal pressure. That is clear. One way would be to prosecute US Person taxpayers for not filing FBARs or not reporting income earned through financial accounts abroad. But the TIGTA report suggested that the IRS might not have sufficient data for such a crackdown. If so, could IRS attention turn elsewhere? Perhaps and, thus, the real question for us is: What will be the consequences for Swiss and non-Swiss Reporting FIs? With that in mind, I contemplated a few scenarios and then thought through the ramifications, as set forth below.
Possible Outcome 1 - The IRS implements the agreed-upon TIGTA recommendations with a keen eye for Reporting FIs that repeatedly submit TINs identified as inaccurate.
How many ROs would state unequivocally that the TINs on their FATCA reports or Forms 1042-S are 100% correct? Few, if any, is my guess. Therefore, if the IRS decides to review the FATCA-related submissions - current, future and perhaps past - many reports and submissions will need to be revised. That means lots of busy work for Reporting FIs that must re-process rejected submissions, re-confirm TINs from account holders and potentially argue with the IRS where the account holder confirms an original TIN different from the IRS one.
In the short term, this scenario threatens a broad, but shallow ripple across the marketplace. It means that many Reporting FIs will need to re-document US Person account holders and prepare amended reporting. In the longer term, these Reporting FIs will need to invest more in operational processes in order to upgrade and monitor their TIN collection process. The alternative - an on-going stream of reports submitted with bad TINs - could lead to unwelcome IRS scrutiny.
Possible Outcome 2 - An under-resourced IRS cannot implement the audit revisions in a timely fashion, but needs to deflect the pressure to enforce FATCA more strictly.
In this scenario, the IRS adopts the old Chinese adage: Kill the chicken to scare the monkey. By ostentatiously cracking down on blatant non-compliance by means of a few, high-profile examples of punishment, the IRS will spook the rest into compliance, thereby relieving the auditor pressure temporarily while it pursues the agreed-upon fixes.
One source of ammunition for such an assault could be amnesty programs, plea bargains or the like. As the Justice Department did with Wegelin & Co. - the Swiss bank it torpedoed in order to jump-start the so-called Swiss Bank Program - the IRS might amass evidence of FATCA non-compliance against a bank vulnerable to the imposition of FATCA withholding. If a few client advisors helped a few well-heeled US Person account holders to avoid FATCA reporting and the Reporting FI cannot point to a top-notch compliance program that should have thwarted such misdeeds, the IRS could claim non-compliance sufficient to revoke its FFI Agreement. While its discretion is tempered somewhat for Model 2 IGA FIs and there is a 12-month period afforded Swiss FIs to address such claims, the prospect alone of revocation could be damning. If executed, such a revocation would convert the Reporting FI into a Non-participating FFI and other banks would start withholding on US-source FDAP payments made to it in its role as intermediary, essentially freezing the bank’s account holders out of the US capital markets and thus presumably triggering asset flight and cratering the share price.
The potential objects of such a campaign are in the unenviable position that they already committed the infractions for which they could be punished. All is not lost, however, for any Reporting FI concerned that it could be vulnerable to a charge of substantial non-compliance. The review of the Reporting FI’s FATCA compliance program, an element of the pending RO Certification process, is an ideal time to identify and redress concrete errors through amended reporting and systematic defects though compliance program enhancements. Such efforts would help the Reporting FI to depict the FATCA violations as the actions of rogue employees, rather than any institutional negligence. Conversely, any Reporting FI with serious compliance lapses known to the IRS whose RO submits an unqualified certification will be a ripe target for enforcement action.
Possible Outcome 3 - Some other form of heightened enforcement entirely.
The IRS may well have multiple FATCA enforcement strategies under development and ready to be unleashed. Timing-wise, it makes sense to have waited until non-compliant FIs had the chances to miss multiple action deadlines and thus will struggle to argue in their defense that they are just a bit late in getting everything in order, but are acting in good faith. At this point, non-compliance across multiple reporting cycles and potentially with the RO Certification will carry the whiff of reckless or intentional disregard for compliance duties, rather than innocent oversight.
Examples of abuses endemic to FATCA that the IRS might be primed to confront include:
Possible Outcome 4 - A combination of some or all of the above?
As the fairly breezy analysis of IRS enforcement options set forth above suggests, the IRS has an array of options, doubtless many of which I overlooked. As with much of FATCA implementation, enforcement too will be new. Accordingly, the IRS may adopt a multi-pronged approach in order to test which specific approach is most effective. Hopefully, in spite of the internal pressure, the IRS will not shoot first and ask questions afterwards.
The 2017 Tax Bill (commonly referred to as the Tax Cuts and Jobs Act or TCJA) expands the scope of (and further complicates the application of) the CFC/Subpart F rules. As mentioned in my earlier blogs on the 2017 Tax Bill, the potential impact on non-US investors needs to be assessed. The impact does not stop there however. Far from it. Many US Person taxpayers face the prospect of sudden inclusion in a regime that previously did not implicate their holdings and consequent surges in taxable phantom income over the coming years. Moreover, their non-US investment partners may start asking them questions about their unrelated holdings for their own CFC/Subpart F purposes. In short, these are the sorts of changes that catch law-abiding taxpayers unawares until the IRS deficiency notice arrives bristling with interest and penalties.
First though, some light background music: The CFC/Subpart F rules, in simplified essence, oblige US Shareholders of Controlled Foreign Corporations (CFCs) to include in current taxable income relevant items of income earned by such CFC (so-called Subpart F income), even if not yet distributed to the US Shareholder via a dividend. The theory underlying this special treatment is that US Person taxpayers should not be permitted to defer the recognition of income by holding it through an off-shore corporation if such US Person taxpayers could compel the corporation to pay them a dividend, which would be taxable under the standard income taxation provisions of the Internal Revenue Code. Basically, you cannot defer taxation on income earned through a foreign corporation so long as it’s within your power to cause it be taxed. The core concept is relatively straightforward, but the rules rely on several specifically defined terms, the scopes of which determine inclusion or exclusion from the regime and any of which might present tricky analyses in certain taxpayer situations. Further, these definitions just acquired a few more wrinkles. This blog addresses four major modifications to key definitions, while leaving aside a host of more minor modifications.
Modification to a "US Shareholder"
Prior to the 2017 Tax Bill, the term, “US Shareholder” for Subpart F purposes generally covered any US Person owning 10% or more of a non-US corporation by vote of all classes of outstanding shares. The limitation to voting shares was logical as the aim of these rules was to capture US Persons with the authority to compel the non-US corporations to cough up a dividend. As such, the amount of holdings by value was, in theory, inconsequential. In addition to segregating those with real control from those with purely passive investment stakes, however, it tended to incentivise tax planning. No surprises there. Affected taxpayers sought to restructure their holdings of possible CFCs in order to reduce formal voting control below10%, while retaining actual control and full entitlement to economic benefits. For that reason, presumably, the 2017 Tax Bill adds US Persons owning 10% or more of a non-US corporation by value of all classes of outstanding shares to the definition of US Shareholder. As such, more lucky folks will qualify as US Shareholders of CFCs.
Modification to a "Controlled Foreign Corporation"
The term CFC generally covers any non-US corporations owned greater than 50% by vote or value – directly or indirectly – by US Shareholders. In calculating the percentages of ownership for this purpose, certain attribution rules per §318 apply. The CFC definition long required the application of the so-called upwards attribution rules. As a result shares owned indirectly by a US Person through an entity (of any type, including, corporations, partnerships, trusts or estates) would be treated as constructively owned by that US Person for purposes of this calculation. The 2017 Tax Bill adds downwards attribution to the possible additional sources of constructively owned shareholdings in a CFC.
What is this downwards attribution and how does it work? Well, if upwards attribution means that the holdings of an entity are attributable to its owners (e.g. shareholders, partners, beneficiaries, as the case may be), downwards attribution is the flipside of that: The holdings of one of an entity’s owners may be attributed to the entity itself. For example, in a sister company scenario, the presence of a US subsidiary alongside a non-US subsidiary, both wholly-owned by a non-US holding company, would now result in the downwards attribution of the holding company’s shares in the non-US subsidiary to the US subsidiary. As a result, the non-US subsidiary would qualify as a CFC and any US Shareholders (including US corporations) of the non-US holding company would start incurring potentially includible income if they previously hadn’t. Overall, many more non-US corporations will qualify as CFCs unless the IRS narrows the application of this rule (or suspends it, as it did per Revenue Notice 2018-13 for the Transition Tax rule described below).
As an aside to non-US investors: Due to these downwards attribution ownership rules, the holdings of US Person co-investors may affect your own investments because some of your US holdings may need to start paying more tax than previously as they now qualify as CFCs.
Modifications to includible income (two major modifications here)
Last but not least (actually, last and most of all), the 2017 Tax Bill expands the types of income earned by CFCs that must be treated as currently includible in the incomes of their US Shareholders. While not technically Subpart F income, the rules newly treat the following amounts as currently includible for US Shareholders of CFCs: Deferred foreign income corporation (DFIC) earnings and profits (E&P) and Global Intangible Low Tax Income (GILTI).
The Transition Tax
DFIC taxation per §965 (a/k/a the Transition Tax) is the levy on any post-1986 accumulated E&P of Specified Foreign Corporations that was not yet distributed or otherwise subject to US federal taxation (for further elaboration on this topic, please refer to my prior blog, The Trump Tax Bill: What it means in Switzerland (Part III)). Not all Specified Foreign Corporations are CFCs; it is a broader definition. However, all CFCs are Specified Foreign Corporations, meaning that all CFCs with positive and as-yet untaxed post-1986 accumulated E&P must pay the Transition Tax, which may be paid in installments over eight years. US Shareholders of CFCs with calendar year tax periods owe the Transition Tax starting for tax year 2017, which is thus evidently due by 17 April 2018. Presumably, therefore, in advance of this date, affected US Shareholders must calculate the total amount owed and commit to the installment plan. Somehow. To further complicate the matter, so far, the IRS has issued no forms or guidance on the process. A postponement to this particular deadline may seem inevitable, but even a laxer timetable will necessitate prompt action.
Whereas the Transition Tax is one-time levy on historical income irrespective of its derivation, GILTI under §951A, on the other hand, is an on-going tax on contemporaneous income flows derived from intangible assets. Its underlying objective is to disincentivize the stashing of IP and other intangible assets in low-taxed overseas subsidiaries. It aims to achieve this objective by compelling US Shareholders to include a portion of this income earned by CFCs in their current taxable income prior to the payment of any dividends. An in-depth explanation of the formula used to isolate the specific class of income targeted is beyond the scope of this blog. In essence, however, it taxes a certain amount of the net income earned by a CFC that is not otherwise taxable (e.g. as ECI, Subpart F income, etc.), but reduced by 10% of the adjusted costs bases of depreciable (but not amortizable) assets held by the CFC (an amount itself reduced by interest expenses). The low tax jurisdiction component is implicated by FTCs allowable for 80% of the taxes paid on the income by the CFC (subject to §904 bucket limitations). In short, if a CFC in a low tax jurisdiction is earning mainly non-passive income and holding mainly intangible assets, its US Shareholders are supposed to be handing a portion of that income over to the US fisc each year.
Part I of this blog series addressed the larger thematic issues for Swiss financial institutions and investors from the new US tax code provisions. Part II set out the scope and consequences of the reduced corporate tax rate and changes relevant to taxation of certain US investments. Part III explores several more relevant topics, including the movement towards a territorial tax system for US corporations and notable miscellaneous provisions before ending with a light-hearted, non-technical look at some of the more idiosyncratic elements of the Trump Tax Bill.
Towards a Territorial Tax System
Most countries operate a territorial tax system. That means, that income is taxed where earned, irrespective of where the taxpayer is located. Historically, the US does not. Instead, the US relies on a quasi-territorial system for corporate tax under which a US corporation was subject to taxation on income earned by its subsidiaries abroad. However, the US parent could defer such taxation until the subsidiary distributed such earnings to the parent by means of a dividend. Receipt of such a dividend payment often entitled the US parent corporation to claim a foreign tax credit (FTC) for taxes paid by the subsidiary in its home jurisdiction. Nonetheless, for dividend payments from subsidiaries operating out of tax-friendlier jurisdictions, the FTC was substantially lower than the tax rate imposed in the US. Therefore, many US corporations hoarded cash in overseas subsidiaries, rather than repatriate it. This approach was upended in December.
Per the new tax bill, dividends paid from non-US subsidiaries (or at least the portion consisting of non-US earnings) are entitled to a 100% dividends received deduction (DRD). The result of this DRD is non-taxation of such dividends for the US corporate parent (provided it owns 10% or more of the non-US subsidiary). In parallel, the provision granting an FTC for any taxes paid by the non-US subsidiary is repealed (as is any FTC attached to any dividend entitled to the 100% DRD). The overall re-shaping through these two changes looks a lot like a move to a pure territorial tax system.
However, there are other international bits of the US tax code – new and pre-existing – that maintain some aspects of the previous universal (i.e. non-territorial) system. The most obvious one is the treatment of the historical aggregate earnings and profits (E&P) of the non-US subsidiaries that were not yet distributed (i.e. the amount that would have been subject to US taxation had the dividends been paid under the previous system). Per the recent changes, this E&P will be deemed to have been repatriated (i.e. paid to the US parent as a dividend), even though it was not yet. This hoarded E&P will be taxed at varying rates, depending essentially on whether it is held in liquid (cash or equivalent) or non-liquid form (15.5% and 8%, respectively). The amount owed pursuant to the deemed repatriation provision may be paid in installments as set forth in the tax code. Once taxed, dividends containing such historical E&P are also entitled to the 100% DRD deduction.
Furthermore, certain exceptions will constrain the 100% DRD going forward, such as:
Oddly, branch profits remittances seem not to enjoy similar tax exemptions, remaining subject to the existing quasi-universal system with US headquarters taxed on the difference between the local tax rate and the new US corporate tax rate. Additionally, a new loss limitation basket for FTCs was introduced specifically for foreign branch operations. This differential treatment is bound to influence the business judgment of US corporations when deciding on the form of their overseas operations. All things being equal, branch operations will be less attractive economically due to their US tax treatment. This differential seemingly violates a cardinal norm of international taxation: To avoid tax rules that distort business decisions.
Meanwhile, in other parts of the tax code, the non-territorial aspects of the US corporate tax regime continue to prevail. Foremost, the controlled foreign corporation (CFC) rules remain intact, meaning that certain non-US corporations owned in part by US Persons will continue to pay US taxes on specified types of current income earned outside the US. Moreover, new treatments for certain types of income derived from intangible assets further muddy the subpart F waters. Non-US investors ought to take another look at the rules governing CFCs – the new ones and their effect on the existing ones – in order to spot any knock-on consequences to their investments.
Miscellaneous Items of Interest
Scattered changes that merit a mention include the following:
In order to close on a lighter note, let’s consider some of the odder elements of the Trump tax bill. Sometimes, strange revisions may address quirks or lacunae in the current rules and are thus bonafide clean ups of debris leftover in the tax system from previous revisions. However, other times, these curios are the products of the personal leverage of individual politicos over the drafting process. Such “pork-barrel” provision are promoted by or promised to one or a small cadre of legislators for the benefit of a narrow and/or local constituency. A few provisions in the new bill stand out as particularly peculiar (and smell a bit bacon-y), such as:
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Part I of this blog series addressed the larger thematic issues for Swiss financial institutions and investors from the new US tax code provisions. Part II will explore the first of several significant topics, coupled with an analysis of the implications for Swiss financial institutions and investors.
Competitive Corporate Tax Rates
Prior to the Tax Cuts and Jobs Act, the US imposed one of the developed world’s steeper corporate tax rates at 35% (coupled with a further tax of up to 39.6% on the shareholder for dividends received). The new bill slashes that rate to 21% (and repeals the alternative minimum tax for corporations). The business- and investor-friendliness of this rate reduction is indisputable. In a flash, it will enhance the post-tax return on investment for US corporations, which ought to make the US operations of Swiss companies more profitable and the investment holdings of non-US investors more valuable. As noted in Part I of this series of blogs, numerous non-tax factors may mitigate the intended impact, but the tax wind clearly gusts in the direction of higher corporate post-tax profits and thus presumably a more attractive investment destination (for further illustration of this attractiveness, please see ECI section below).
One quirk of the rules for tax accounting, however, will result in an immediate harm to the balance sheets of US corporations (both US-headquartered companies or the subsidiaries of non-US parents) due to the reduction of the corporate tax rate. This harm is superficial, but may lead to some holes on the asset side of the balance sheets for US corporations with significant accumulated losses (called “net operating losses” in tax parlance or NOLs, for short). The US tax code permits US corporations to carry forward NOLs from one year for use against positive earnings in future years (subject to multiple limitations). As such, NOLs are valuable for reducing future tax costs and thus may be treated as an asset in the financial reports of the corporation. For accounting purposes, the amount of future deductible losses is known as a deferred tax asset (DTA) and boosts the asset side of a balance sheet so long as the corporation has a reasonable expectation that it will earn enough income to offset it in future years before it expires.
Well, in 2008 a lot of banks lost a lot of money. A LOT. Since then, they have been carrying DTAs of up to USD 20B, inflating their balance sheets correspondingly. However, the amount of a DTA is a product of the total NOL multiplied by the corporate tax rate. For example, if you have an NOL of USD 100, it still can only offset USD 100 of future income. Going forward though, the value to the corporation on taxes saved will be 100 x 0.21 or a DTA of USD 21, whereas previously it would have been 100 x 0.35 or a DTA of USD 35. Fortunately, the financial markets tend to discount such tax elements of a balance sheet as they do not signal the overall health and future prospects of the corporation (arguably, a large DTA signals the opposite). Nonetheless, there may be some secondary effects in response to this tax accounting adjustment.
Lower Rates on ECI, an Incoming Withholding Regime and More
Effectively Connected Income or ECI is income earned through a direct investment in an active trade or business (mainly). At its most straightforward, the US branch or other permanent establishment-type operations of non-US corporations generate ECI. Non-US investors can also earn ECI through investments in private equity, venture capital or other investment funds that acquire ownership stakes in start up companies, which tend to operate as LLCs or in other flow through forms. In the absence of a “blocker” corporation, the earnings of the portfolio companies pass through to the investment fund and then on to the non-US fund investors as if such non-US fund investor had earned the active operating income directly. Accordingly, income earned through such investments is taxed at the rate applicable to US corporations, not the standard dividend or capital gains rates that typically avail for non-US investors in US securities.
The new tax bill contains several provisions that will affect ECI calculations for non-US investors. It also institutes a new withholding requirement that will impose a further operations burden on QIs and other withholding agents. The core changes are as follows:
Part III of this blog series dissecting the new US tax code provisions will be published in a few days’ time. If you wish to be automatically notified when it’s posted, please send an email to email@example.com and you will be added to our subscriber list.
Hey, anyone hear the one about the new tax rules enacted by the US Congress in late 2017? Of course, we all did. Inevitably, unavoidably, somewhere, sometime in December, we read or heard something about the new US tax bill signed into law just before Christmas. However, what you have heard about it might be irrelevant to your circumstances or, worse, might generate “white noise”, distracting you from what is in fact relevant to your circumstances. Even more worrisome, the distinction may not be clear. The modification of an organism as vast, complex and ungainly as the US Internal Revenue Code is like dredging an ocean harbor to install port facilities: From the perspective of the harbor, the entire ocean is now different; from the perspective of the ocean, nothing much has changed at all. Therefore, a beneficial analysis of tax code revisions must understand when its readers are in the ports and when they are in the middle of the ocean.
Accordingly, this blog (or rather set of blogs) will seek to do just that, concentrating on the elements of the new tax laws that are relevant – either directly or indirectly – to its core readership: Swiss financial institutions and Swiss (or other non-US) investors in US financial assets. Thus, it will de-emphasize the parts that have little impact on an international readership (even the…. drumroll please… HEADLINE political news). Finally, it will seek to present a three-dimensional view of the package of changes that affect a specific type of non-US taxpayer or industry, rather than simply listing each changed provision while expecting the reader to integrate the various parts into a comprehensive understanding of the new US tax landscape.
As I am a tax specialist, you’ll not be surprised when I begin with caveats. The blog will not cover the following topics in detail, though some or all may be critical to the impact of the new tax bill:
And thus, we move onwards to Part II, the actual analyses of the bill, which will be posted over the coming days and feature the following themes:
Part II of this blog series dissecting the new US tax code provisions will be published in a few days’ time. If you wish to be automatically notified when it’s posted, please send an email to firstname.lastname@example.org and you will be added to our subscriber list