When Alice found herself in Wonderland, she observed a recognizable world that had been turned on its side. So too do we find ourselves in FATCA-Land; logic and proportion, while recognizable, are unfamiliar. In Wonderland clocks ran backward and animals could talk; in FATCA-Land virtually all Canadian private trust or estates are treated as banks.1
The Foreign Account Tax Compliance Act (FATCA) legislation is stunning in its ambition, reach and complexity, and as a result, this article will discuss only a few of the most important issues that arise under the Intergovernmental Agreement (or “IGA”) recently executed by Canada and the US. These issues include: classification of trusts, the issues with TFSAs, RRSPs, etc., and an identification of potential problems with Canada’s draft legislative proposal.
As a resident of Canada, complaining about FATCA is a lot like complaining about the weather – it makes us feel better but doesn’t change it. Fortunately the IGA mitigates the worst of the effects of FATCA and all right minded people would agree that life under the IGA is much better than would have been without it. The Department of Finance of Canada did a great job explaining its reasoning for entering into the IGA and what was averted by doing so.2
After the terrorist attacks on 9/11, the US realized that its position in the global economy coupled with pressure on the global banking system could prove to be a very powerful weapon to fight money laundering and terrorism.3 In 2010 the US congress enacted FATCA, which utilizes the strategies perfected post-9/11 to prevent US citizens from hiding income and assets in foreign jurisdictions.
FATCA is a whopper of a piece of legislation. While the statute4 is relatively brief (3,362 words in fact) the regulations are punishingly voluminous and complex. Including the preamble, the regulations take up 522 pages… and there are no pictures. Attorney Peter Cotorceanu deftly noted “It’s a leviathan. And it breaths fire.”5
When reduced to its essence, FATCA classifies every non-US business, non-US entity, and non-US legal relationship as either a Foreign Financial Institution (or “FFI”) or a Nonfinancial Foreign Entity (or “NFFE”) and imposes certain obligations depending on the classification.
Generally, FFIs are obligated to report US person customers to the IRS, though under the IGA the reporting is to the Canada Revenue Agency (or “CRA”). On the other hand, NFFEs are obligated to report their US person owners to the withholding agent (the payors) when receiving certain types of payments from US sources.
Since the rules and penalties are different for FFIs and NFFEs it is critical to accurately determine the appropriate classification from the outset.
The reporting obligations and penalties for failing to comply are set forth in the gargantuan set of regulations referenced above. The regulations need not be the end of the story, however. If a foreign government enters into a Model 1 IGA, that agreement supersedes much of the regulations, and reporting obligations and penalties become a lot less onerous.
Most Canadian private trusts (and estates) are FFIs according to the IGA.
Whether the US congress intended to classify trusts as FFIs when it enacted FATCA in 2010 is unclear. The term “trust” is mentioned only six times in the statute and never in the context of a FFI. Since we’ve already arrived in FATCA-Land, however, fretting about congressional intent doesn’t improve our situation. We’ll just have to carry on. As should become clear, the IRS (which drafted the regulations) and Treasury (which drafted the IGA) certainly did intend to classify trusts and estates as FFIs.
The analysis begins easily enough with looking to the Subparagraph 1(g) of Article 1 of the IGA, which defines the term “Financial Institution” to include Custodial Institutions, Depository Institutions, Investment Entities, and Specified Insurance Companies. In the trust context, only the “Investment Entity” definition is relevant.
Subparagraph 1(j) of Article 1 of the IGA provides:
The term “Investment Entity” means any Entity that conducts as a business (or is managed by an entity that conducts as a business) one or more of the following activities or operations for or on behalf of a customer:
(1) trading in money market instruments (cheques, bills, certificates of deposit, derivatives, etc.); foreign exchange; exchange, interest rate and index instruments; transferable securities; or commodity futures trading;
(2) individual and collective portfolio management; or
(3) otherwise investing, administering, or managing funds or money on behalf of other persons.
If that definition made sense the first time you read it, then you didn’t read it closely enough. It’s a tough one to get through, but here’s how it works.
The first step to understanding the definition is to read it without the parenthetical numbered paragraphs:
The term “Investment Entity” means any Entity that conducts as a business … one or more of the following activities or operations for or on behalf of a customer
At this step, it should be clear that a trust or an estate does not fit the definition of Investment Entity because A) neither have “customers”, they have beneficiaries and Treasury Regulation 301.7701-4(a) confirms this; or B) neither conduct “business” and Treasury Regulation 301.7701-4(b) confirms this.
Further, astute practitioners will quickly point out that in Canada, a trust is not an “Entity” but a “legal relationship.” Unfortunately for those who hoped for a quick end to the analysis, the term “Entity” is defined in subparagraph 1(gg) to mean “a legal person or a legal arrangement such as a trust.” Thus, we must wallow on to step two. However, we will return to the “Entity” definition in step four.
The second step is to read the definition with the parenthetical (though without the numbered paragraphs):
The term “Investment Entity” means any Entity that conducts as a business (or is managed by an entity that conducts as a business) one or more of the following activities or operations for or on behalf of a customer
Thus, it should be clear (or less murky) that even though a trust or estate alone will not be classified as an Investment Entity (and therefore an FFI), if it is managed by an entity that is in the business of providing the three enumerated services to customers, then it will be an Investment Entity (and therefore an FFI). Interestingly, the parenthetical language isn’t found in the regulations, but it is found in the IGA.
The third step is to consider what is meant by “managed by.” The IGA does not define “managed by” but examples 5 and 6 of the Treasury Regulations found at 1.1471-5(e)(4)(v) give us some guidance. The examples show that the management component means either management of the trust or estate itself or management of the investment assets of the trust.
In other words, the management component is satisfied and the trust or estate is an Investment Entity if the trust or estate has a professional trustee (that is in the business of providing enumerated services for customers). Likewise the management component is satisfied and the trust or estate is an Investment Entity and has a professional asset manager.
There are a lot of open questions regarding the management test that are not addressed in the regulations, the IGA, or anywhere. For example, is there a de minimus standard? What if the investment manager is unable to execute trades without the consent of the trustee? What if the assets are invested in an exchange traded fund that doesn’t trade the underlying assets? We are hopeful that these questions will be addressed very soon.
The fourth step is to revisit the term “Entity.” Recall that the term Entity is defined in subparagraph 1(gg) of Article 1 of the IGA. The term Entity is limited to legal persons. The term legal persons is not defined in the IGA or regulations, but since the term natural person is used in subparagraph 1(mm) of Article 1, it is reasonable to conclude that the management requirement is met only when the manager is not a flesh-and-blood person.
To summarize: the trust or estate will be an Investment Entity and therefore an FFI if it:
- It has a professional trustee; or
- Has a professional money manager; and
- The professional trustee or manager is not a flesh-and-blood person.
Is this the correct analysis? Based on logic and statutory analysis we would have to conclude that it is, but in the higgledy-piggledy world of FATCA Land, reliance on logic and statutory analysis does not assure the correct outcome. However, we can gain comfort in our analysis by looking to the UK-US Guidance Notes for confirmation.6 Section 2.36 provides confirmation of the foregoing analysis:
A Trust will be an Investment Entity and therefore a Financial Institution where the Trust or Trustee engages and other Financial Institution to manage the Trust or Financial Assets on its behalf.
The UK has taken the lead in IGA negotiation and implementing legislation, though we’re still talking about very recent history and, as a result, the law hasn’t had much time to evolve in this regard. The UK IGA was the first one signed (September 12, 2012) and its Guidance Notes were the first issued (May 31, 2013). Notwithstanding dewy state of the UK’s Guidance Notes, they do give some guidance, and in FATCA Land we take our comfort where we find it.
TFSAs, RESPs, RRSPs, RDSPs etc. are also FFIs… but there’s some good news
Cross-border practitioners will recognize that certain Canadian retirement plans are considered foreign trusts under US law.7 As trusts they will all be considered FFIs if they have professional (“Entity”) managers.
Since these entities are FFIs, are they obligated to follow all the same rules as banks? The short answer is “no.” In order to have the reporting obligations, the entity must be both FFI and a Reporting Canadian Financial Institution. Subparagraph 1(o) of Article 1 of the IGA provides that a Reporting Canadian Financial Institution is anything that is not a Non-Reporting Canadian Financial Institution. Subparagraph 1(q) of Article 1 directs us to Annex II for a list of Non-Reporting Canadian Financial Institutions, which includes Exempt Beneficial Owners. Paragraph C(1) of Article II of Annex II provides that retirement funds described in paragraph 3 of Article XVIII of the Treaty are Exempt Beneficial Owners and therefore Non-Reporting Canadian Financial Institutions.
FATCA is a fire-breathing leviathan, remember?
To summarize, while TFSAs etc., are FFIs, they are Non-Reporting FFIs and therefore not subject to report information on their accounts to CRA.
Aside from the FFI analysis, it is important to note that the IGA afforded the above-referenced accounts a very important additional benefit. The benefit is that Article IV of Annex II of the IGA exempts these accounts from the general reporting rule for FFIs. In other words, the banks that custody this type of account are not obligated to report these accounts to CRA.
Why is classification as an FFI or an NFFE so important?
Selecting the FATCA filing status is critically important for two reasons: US compliance and Canadian compliance.
From a US perspective, the filing obligations are different for FFIs and NFFEs. As mentioned earlier, under the IGA, FFIs report account information of US persons to the CRA. Conversely, NFFEs report ownership information when they receive certain US source payments. The additional due diligence requirements, reporting obligations, and penalties amount to a 522 page cudgel that I won’t bludgeon you with in this article (you’re welcome, by the way).
The compliance burden is generally higher if the entity is a FFI, but that is not always the case. Individual facts dictate the burden. Your mileage may differ.
The Canadian compliance perspective is much more interesting.8 The draft legislation imposes filing obligations and penalties on Reporting Canadian FFIs, but there are no concomitant obligations for NFFEs. This is likely because of the reasons articulated above: Canadian FFIs report information on accounts to the CRA, while NFFEs report ownership information to the withholding agent (payor) of certain US source income.
Common in both the IGA9 and draft legislation10 is the obligation that all Reporting FFIs report “Nonparticipating FFIs” to the CRA. “Nonparticipating Financial Institution” is defined in subparagraph 1(r) of Article 1 of the IGA, which will basically catch all Canadian trusts and estates that are unaware of their classification under FATCA.
It’s important to keep in mind that classification issues aren’t elective. You can’t choose to be one type of entity or the other. The entity is either FFI or NFFE. Getting into the appropriate box is a critical determination.
Concerns with the draft legislative proposal
Long before the IGA and the draft legislation were announced, Canada’s preeminent constitutional law professor Peter Hogg opined that any implementation may violate Canada’s Charter of Rights and Freedoms.11 Professor Hogg may be completely correct, and I am certainly in no position to challenge Professor Hogg on his Charter analysis or conclusions. Further, Allison Christians wrote an eloquent article on the dubious nature of IGAs and I do not disagree with her analysis.12 Instead, I will address only the tax-related issues with the proposed legislation. Further, the following discussion includes only the major issues that possibly affect trust status as FFIs.
The fact that the draft legislation is in need of some clarification is not surprising. The fire-breathing leviathan is complex, lacks precedent, and is new on the global stage. Seldom is legislation birthed fully formed and functioning and, in light of FATCA’s complexity, right minded people would expect there to be changes.
First, the draft legislation would exclude private trusts and estates from being classified as FFIs. The biggest concern with the proposed legislation is that proposed paragraph 263(2)(g)13 defines “Financial Institution” in a manner that is incongruous with the definition set forth in the IGA. Draft paragraph 263(2)(g) provides:
(g) The term “Financial Institution” means any Entity that is a Custodial Institution, a Depository Institution, an Investment Entity or a Specified Insurance Company, and that is
The draft legislation then lists an exclusive list of 1114 types of entities that could be classified as an FFI under the IGA. The problem with this exclusive list is that it does not include trusts or estates that, per the analysis of the IGA and regulations, would otherwise be included in this definition.
Of course we are not privy to the negotiation of the IGA and the inconsistency could be by design and not a simple omission. In any event it should be clarified so trusts and estates are not misled into entity classification that is sanctioned in Canada but to which the IRS takes issue.
Second, the tenth item listed in proposed paragraph 263(2)(g) both over and under includes certain parties as FFIs. The tenth item provides that an FFI can include:
“a certain person or entity authorized under provincial legislation to engage in the business of dealing in securities or any other financial instruments, or to provide portfolio management or investment advising services”
As discussed above, subparagraph 1(gg) of Article 1 of the IGA provides that flesh-and-blood people can’t be FFIs. Since the proposed paragraph includes the term “person or entity”, it potentially includes parties as FFIs that the IGA would exclude. Conversely, and as discussed above, under Canadian law trusts are not entities, but under the IGA they are specifically included in the definition. Thus by including the term “entity”, the proposed paragraph is also overly exclusive of the parties who may be classified as an FFI.
“I can’t go back to yesterday because I was a different person then.”
Lewis Carroll, Alice in Wonderland
Non-US trusts occupy an unenviable position in FATCA-Land. Most will be classified as Financial Institutions and therefore will have to carefully navigate the vagaries of domestic and international law in order to avoid the consequences of inadvertent non-compliance. The Canada-United States IGA goes a long way to mitigate the compliance cost and consequences of non-compliance but, as noted, some clarifications are required.
Just as Alice couldn’t go back to the person she once was, neither can we go back. FATCA has changed the global banking, business and tax landscape – and more changes will follow.
1. In FATCA-speak, however, we seldom use the term “bank” instead we say “Foreign Financial Institution” (which the hip kids further reduce to “FFI”).
2. See, Canada and U.S. Reach Agreement on Foreign Account Tax Compliance Act http://www.fin.gc.ca/n14/14-018-eng.asp; FAQ: FATCA and the Intergovernmental Agreement for Enhanced Exchange of Tax Information under the Canada-U.S. Tax Convention http://www.fin.gc.ca/afc/faq/fatca-eng.asp;
3. Those interested in the antecedents of FATCA and how the US Treasury discovered and honed its skills should read Juan C. Zarate’s book entitled Treasury’s War: The Unleashing of a New Era of Financial Warfare (2013).
4. 26 U.S.C. 1471-1474
5. Cotorceanu, “FATCA and Offshore Trusts: The First Nibble” Tax Notes, April 23, 2013. Mr. Cotorceanu has undertaken the Herculean task battling the leviathan in two excellent expository articles of which the prior citation is one. The other is Cotorceanu, “FATCA and Offshore Trusts: a Second Bite of the Elephant.” Tax Notes, September 4, 2013.
6. HMRC, “Implementation of International Tax Compliance (United States of America) Regulations 2013 Guidance Notes” (2013) (published August 14, 2013), section 2.36.
7. See Revenue Procedure 2002-23 for additional details of covered Canadian plans. Rev. Proc. 89-45, 1989-2 CB 596 was superseded by Rev. Proc. 2002-23, 2002-1 CB 744.
8. The proposed Canadian legislation is entitled Legislative Proposals Relating To the Canada-United States Enhanced Tax Information Exchange Agreement and can be found at the following link: http://www.fin.gc.ca/drleg-apl/2014/can-us-eu-0214l-eng.asp
9. Subparagraph 1(b) of Article 4 of the IGA.
11.Letter from Professor Peter W. Hogg to Department of Finance (December 12, 2012): http://www.greenparty.ca/sites/greenparty.ca/files/attachments/peter_hogg_fatca.pdf
12. Christians, The Dubious Legal Pedigree of IGAs (And Why It Matters) Tax Notes International February 11, 2013.
13. LEGISLATIVE PROPOSALS RELATING TO CANADA-UNITED STATES ENHANCED TAX INFORMATION EXCHANGE AGREEMENT http://www.fin.gc.ca/drleg-apl/2014/can-us-eu-0214l-eng.pdf
14. The exclusive list is as follows:
g) The term “Financial Institution” means any Entity that is a Custodial Institution, a Depository Institution, an Investment Entity or a Specified Insurance Company, and that is
(1) an authorized foreign bank within the meaning of section 2 of the Bank Act in respect of its business in Canada, or a bank to which that Act applies;
(2) a cooperative credit society, a savings and credit union or a caisse populaire regulated by a provincial Act;
(3) an association regulated by the Cooperative Credit Associations Act;
(4) a central cooperative credit society, as defined in section 2 of the Cooperative Credit Associations Act, or a credit union central or a federation of credit unions or caisses populaires that is regulated by a provincial Act other than one enacted by the legislature of Quebec;
(5) a financial services cooperative regulated by An Act respecting financial services cooperatives, R.S.Q., c. C-67.3, or An Act respecting the Mouvement Desjardins, S.Q. 2000, c. 77;
(6) a life company or a foreign life company to which the Insurance Companies Act applies or a life insurance company regulated by a provincial Act;
(7) a company to which the Trust and Loan Companies Act applies;
(8) a trust company regulated by a provincial Act;
(9) a loan company regulated by a provincial Act;
(10) a person or an entity authorized under provincial legislation to engage in the business of dealing in securities or any other financial instruments, or to provide portfolio management or investment advising services; or
(11) a department or an agent of Her Majesty in right of Canada or of a province that is engaged in the business of accepting deposit liabilities.