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Under the Foreign Account Tax Compliance Act (FATCA)
The classifications of (i) a trust and (ii) the company underlying the trust and holding Financial Asset depends on several factors, namely the IGA jurisdictions of the two entities and their operations with respect to those Financial Assets. Moreover, those FATCA classifications determine the FATCA due diligence and reporting obligations of the two entities and any third-party Foreign Financial Institutions (FFIs) where the assets are held.
In summary, where the underlying company holding the Financial Account with the third-party FFI qualifies as a Professionally Managed Investment Entity (PMIE) FFI in a IGA Jurisdiction, the bank or other FFI maintaining the account will neither look through the PMIE to document its owners nor report on the entity. Likewise, the PMIE underlying company will neither look through the trust to document its owners nor report on the trust because the trust will adopt the classification of Custodial Institution FI.
Finally, if the trust, as an FFI entity is not resident in any jurisdiction participating in a FATCA IGA, incurs no FATCA compliance duties directly. FATCA imposes a withholding penalty on any payment made to a FFI that does not register for a GIIN or report on its account holders, but only if a US source payment is made.
If no payment is made to the trust, no withholding penalty applies. Also there is no recalcitrant report made on the trust as no payment is made to the trust FFI.
FATCA classification analysis of the structure
The threshold inquiry for any entity classification process under FATCA is whether the entity is governed by the FATCA rules in force in any jurisdiction implementing FATCA and, if so, which ones. The criteria for identifying a jurisdictional nexus with any jurisdiction tend to mirror that jurisdiction’s concept of “tax residence” for purposes of its income tax regime.
Accordingly, corporations tend to be resident where incorporated and partnerships tend to be resident where managed and controlled. Trusts, however, are subject to a special rule because few of them are resident for income tax purposes in any jurisdiction.Accordingly, for purposes of FATCA, trusts are deemed to be resident in any jurisdiction where one or more of the trustees of the trust is resident.
What if the Trust owns 100% percent of the shares of a UK company (the “UC”)?
The UC directly holds assets qualifying as Financial Assets; and some of these Financial Assets are subject to professional management by other FFIs, such as depositary institution or managing investment entity.
As the UC is likely to qualify as a PMIE (per the analysis in the below section) and the Trust holds 100% of its equity interests, the Trust is an Account Holder of the UC. As the UC is resident in the United Kingdom, the Trust must therefore classify itself under the UK FATCA rules. Pursuant to these rules, the Trust may be classified as a Custodial Institution FFI with respect to the Financial Account held in the UC according to the reasoning set forth in the following paragraphs.
A common approach for trusts under FATCA analyses them initially as potential PMIE- FIs. An entity qualifies as a PMIE [1] if it (a) is managed [2] by a Financial Institution (other than a PMIE) and (b) earns at least 50 percent of its gross income from Financial Assets.
Provided that a discretionary trust holds Financial Assets (e.g. a portfolio of securities or the shares of an underlying company), many jurisdictions automatically categorize them as PMIE based on the assumption that the trustee of a discretionary trust conducts sufficiently management-like activities However, that applies only where the one or more of the trustees is also an entity, which is not the case here. Thus, the Trust cannot qualify as a PMIE due to the management authority vested in its trustee because that trustee is an individual.
There is, however, another FFI category for which it may be eligible. The definition of a Custodial Institution FFI is any entity that a) “holds…Financial Assets for the account of others” and b) earns 20% or more of its gross income from providing such services.
[1] There are different definitions for an “investment entity” under the Treasury Regulations and IGAs. Under the Treasury Regulations, a two-part test must be satisfied: (i) an income test; and (ii) the entity must be managed by a “professional manager”. Under the IGA definition, only professional management is required to meet the investment entity definition unless the local IGA allows the US Treasury Regulations to be applied in lieu of corresponding definitions in the Agreement.
[2] A professionally managed trusts is where (i) the trustee is a Financial Institution, or (ii) The trustee (on behalf of the trust) engages a Financial Institution to manage the trust, or (iii) The trustee (on behalf of the trust) engages a Financial Institution to manage the trust’s financial assets, usually be where the trust has appointed a discretionary fund manager to manage some or all of the portfolio, and at least one discretionary investment is made annually.
The text of the first criterion seems to squarely apply to the classic purpose of a trust scenario: To hold legal title in a fiduciary capacity over assets at the behest of the settlor. The United Kingdom’s FATCA guidance concurs, contemplating that FI trusts may be either Custodial Institutions or PMIEs and, furthermore, providing guidance on how to comply with FATCA where the trust is classified as Custodial Institution FI. Thus, it is impossible to state that the Trust does not satisfy the first criterion of the test for a Custodial Institution FI and the United Kingdom’s FATCA rules plainly tolerate such classifications.
As for the gross income criterion – that 20% or more of the entity’s gross income derives from providing such services the United Kingdom provides a useful list of which types of fees would qualify as compensation for “holding financial assets and providing related financial services”.
[1] These include, but are not limited to, financial advisory, custody and account maintenance fees. Such fees, irrespective of their label, are the lifeblood of fiduciary service providers. That conclusion settles the analysis, if and only if those fees are paid to the custodian for such services and they amount to 20 percent or more of the entity’s income.
One early controversy under FATCA was whether the fee income relevant to the gross income test had to be paid directly to the entity providing the services. Or, alternatively, could the custodian’s fees be bundled together with associated fees and paid to another (unrelated) party? The OECD resolved that uncertainty by stating that “all remuneration for the relevant activities… independent of whether that remuneration is paid directly” counts towards the gross income thresholds of the entity in question.
The UK FATCA guidance notes adopted a similar approach, contending that where fees from multiple service providers are bundled together, a portion of the aggregate fee must be attributed to each entity providing a service and thus “consideration should be given to what would have been paid by an arm’s length customer when applying the 20% test [i.e. the gross test income].”The fees paid by the settlor for the services provided through the Trust Structure must be apportioned to the Trust. To the extent that the Trust does not earn a substantially greater amount of other income, it meets the gross income test for a Custodial Institution. Accordingly, the Trust may assume a FATCA classification as a Custodial Institution FFI with respect to its equity interests in the UC.
FATCA classification analysis of the UC
As an entity holding solely Financial Assets and with no other purpose or capacity, the UC’s options for FATCA classification narrow down instantly to a PMIE FFI or a Passive NFE. The determination pivots on whether the UC is subject to professional management (as defined for FATCA) by another FFI.
The United Kingdom defines such professional management relatively narrowly, insisting that the managing entity must “have discretionary authority to manage the entity’s assets either in whole or in part.” Accordingly, where a third-party FFI has the authority to determine the investment decisions of the entity – either as part of the entity’s management team or through a Power of Attorney (including a discretionary portfolio agreement with the custodial bank where the assets are held) – the entity will be a PMIE. As the UC will engage such a third-party FFI to make binding investment decisions over some or all of its assets, the UC will qualify as a PMIE FFI
