Maintain FATCA Compliance, Avoid Trouble

The Major Flaw in CRS and FATCA

Financial institutions do not report on account holders that are themselves financial institutions. This enables chains of entities, with each level classified as a financial institution. The weakness of AEoI arises when the top-level entity is a non-participating financial institution. FATCA and CRS only weakly address this vulnerability, leaving opportunities to establish structures that remain non-reportable.

Non-Participating Financial Institutions – FATCA vs CRS

Under CRS, non-participating Investment Entities are treated as Passive NFEs, requiring a look-through to their controlling persons by the underlying paying agent FI. In contrast, other types of non-participating FFIs are not subject to look-through requirements.

FATCA, however, seeks to penalise non-participating FFIs that fail to register for a GIIN by classifying them as recalcitrant. In such cases, the underlying FFI or paying agent must withhold 30% on any U.S.-sourced payments, such as dividends, interest, or proceeds from the sale of financial assets. FFIs are further encouraged to close the accounts of non-participating FFIs. The limitation, however, arises where no such U.S.-sourced payments are received—for instance, where a custodial institution simply holds shares of a company.

CRS vs FATCA: Open Loopholes

CRS published three FAQs between 2017 and 2019 to address loopholes, along with several CRS addendums, such as those on residence by investment. FATCA never closed these loopholes.

The OECD eventually realized that trying to eliminate loopholes was like stamping on cockroaches and abandoned the effort to address them individually. Instead, it published the Mandatory Disclosure Rules (MDR), requiring developers and promoters of loopholes to report them to their tax authorities. This initiative was largely ineffective, as very few countries implemented the MDR. Even worse, promoters who were lawyers or who resided in non-participating jurisdictions were exempt from reporting.

Among the loopholes the OECD explicitly closed were broad-based retirement plans, nil-value reporting on settlors of irrevocable trusts, and the classification of cash as not being a financial asset.

The structure under focus is a UK non-resident trust categorized as a custodial institution, with its trustee being an individual resident in Svalbard. The custodial institution owns 100% of an investment entity company. No income flows from the investment entity to the custodial institution.

The investment entity reports nil because its equity interest is an FFI custodial institution. The custodial institution trust, an FFI, has no reporting obligations as Svalbard is excluded from the IGA with the US. The custodial institution is a non-participating FFI but avoids the 30% withholding penalty because it receives no income.

What Is an Expanded Affiliated Group (EAG) in FATCA

An expanded affiliated group is generally defined in accordance with the principles of Code section 1504(a). It refers to one or more chains of members connected through ownership by a common parent entity, provided that the common parent entity directly owns stock or other equity interests meeting the requirements of Treas. Reg. §1.1471-5(i)(4) in at least one of the other members (without applying the constructive ownership rules of section 318).

Generally, only a corporation is treated as the common parent entity of an expanded affiliated group, unless the taxpayer elects to follow the approach described in Treas. Reg. §1.1471-5(i)(10).

Source: IRS FATCA Help Guide

FATCA applies the rule of the Expanded Affiliated Group (EAG), which arises when one entity owns more than 50% of another. The EAG concept is used to prevent avoidance of registration and reporting obligations by some members of a group, following a “one bad apple” approach. Under this rule, no foreign financial institution (FFI) may claim non-participating FFI status if any member of the affiliated group is a non-participating FFI (§1.1471-4(e)(1)).

The definition of an EAG is based on common ownership and would, in principle, include structures such as a trust with underlying companies. However, the EAG rules normally apply only to corporations. If one of the owned or owning entities is not a corporation, such as a partnership or a trust, it must make an election to be treated as part of an EAG. Because a trust can be the owning entity and thus serve as the potential common parent, an election under Treasury Regulation §1.1471-5(i)(10) is generally required to treat a non-corporate trust as the common parent for the group.

Advisor Liability Under FATCA

The United States could prosecute the person giving this advice under several criminal statutes, even if the technical claim about Svalbard’s status is accurate. Prosecution would not hinge on the truth of that single fact, but rather on the overall intent, context, and recklessness of the advice.

Here is how the situation breaks down:

• Norway has a FATCA Model 1 IGA with the US. However, this agreement applies to the Kingdom of Norway, while Svalbard is excluded from the definition of the Kingdom of Norway for tax treaties, including the IGA with the US.
• It is therefore plausible that a financial institution located in Svalbard might not be covered by the Norway–US IGA. In that case, the institution would fall under the default FATCA rules as a “non-participating foreign financial institution.”

This is where the advisor’s guidance becomes dangerously incomplete and fraudulent. By omitting critical information, the advisor turns a technical truth into a tool for deception. The US could prosecute because the advice is materially false and misleading by omission—the advisor is using a narrow fact to facilitate a broader falsehood.

FATCA – How Advisors Protect Themselves by Informing Clients

This is a critical follow-up question that significantly changes the analysis. If the advisor provides complete and accurate information on the US person’s reporting obligations, the situation shifts from potentially criminal conduct to a compliant one.

Here are the situations where the US could still penalize the advisor, along with the defenses available.

The Scenario: Compliant Advice. The advisor says: financial institutions in Svalbard may not report trust details under FATCA. However, this does not remove the client’s duty to report the trust and income on FBAR, Form 8938, and Forms 3520/3520-A. Failure to file brings severe penalties.

Why This Advice Is Largely Defensible: The advice is accurate and promotes compliance. The advisor is not hiding assets but explaining obligations. Without willfulness, prosecution is unlikely.

Circumstances Where the Advisor Could Still Face Risk:

• Promoter of an Abusive Tax Shelter (IRC § 6700): If claims are false, the trust is a sham, or fees rely on secrecy.
• Assisting in the Preparation of False Documents: Helping file returns omitting trust income after warnings.
• “Too Cute by Half” (Step Transaction Doctrine): IRS could view the arrangement as unlawful in substance.
• Incompetent or Incorrect Advice: Misstating forms or thresholds can cause civil penalties (e.g., IRC § 6694).