How FATCA will impact financial services in Germany

The Foreign Account Tax Compliance Act (FATCA) was passed in the US on March 18 2010, as part of the Hiring Incentives to Restore Employment Act (HIRE Act). Although many high profile cases involving non-US banks have been reported on recently, the impetus for this legislation was the broader objective of closing the tax gap in the US, which is calculated general as the difference between expected and actual tax revenues.

The gross tax gap has grown in dollar terms (adjusted for inflation) since Internal Revenue Service's (IRS) previous estimate for tax year 2001, increasing from $345 billion to $450 billion for tax year 2006. However, given the growth of the economy and total federal tax liability over that period, the percentage of taxes owed that taxpayers paid voluntarily and on time, known as the voluntary compliance rate, has remained relatively constant–83.7% in 2001 and 83.1% in 2006. To address this, the IRS took a radical approach to first attack what was seen as the low hanging fruit, simply, income which is earned by account holders at financial institutions and not reported by those institutions to the IRS. Statistically the IRS believes that income which is reported dually (to the IRS and the recipient), such as wages, has roughly a 99% likelihood of being reported on the recipient's tax return, whereas in cases where dual reporting is not required, such as capital gains earned in overseas accounts, this percentage drops precipitously to roughly 44%.

Since passage, FATCA has been the bane of financial institutions around the globe. It imposes identification, reporting, withholding and compliance requirements in addition to the execution of an agreement with the IRS by which the financial institution fortifies its intention to comply with the regulations and avoid withholding on its US source income. With the release of the Proposed Regulations on February 8 2012, a joint statement was also released which announced the intention of five European countries (Germany, France, Italy, Spain and the UK) to take an intergovernmental approach to compliance with the regulation whereby these countries would pass local legislation intended to meet the objectives of FATCA and report this information to the US on behalf of the financial institutions within each respective jurisdiction (Model I Intergovernmental Agreement, "Model I IGA").

Switzerland and Japan were the next nations to signal their intention to take an intergovernmental approach to the legislation under different terms (Model II Intergovernmental Agreement, "Model II IGA"). What has resulted is best evidenced by the press release from the US Treasury recently stating that nearly 50 nations are now interested in pursuing an intergovernmental approach to compliance and are in discussions with the US.

FATCA implementation will now involve the interaction of both the regulations in the US and the intergovernmental agreements with related local legislation which is expected to be passed in the course of 2013. The reciprocal version of the Model I IGA provides for an automatic exchange of information with local tax authorities acting as an intermediary (in Germany, reporting through the Federal Tax Agency – Bundeszentralamt für Steuern). The Model II Agreement was published on November 14 2012, in which it is stipulated that the foreign financial institutions (FFIs) will be required to meet the terms of an FFI agreement and report to the IRS directly. Unfortunately, a draft of the FFI Agreement has not yet been released. Given the ever-changing regulatory environment, and the fact that a number of multinational financial institutions are headquartered in Germany, these financial institutions are facing the reality of one regulation that has evolved to create multiple regulatory environments driven by the jurisdiction of the operations which can have dramatic repercussions on implementation if a one-size-fits-all approach is taken.

FATCA must be applied within a diversified German financial services market and will affect all three areas of banking, asset management and insurance. The individual impacts and corresponding implementation measures differ and depend on the size, international reach as well as the operational and legal structure of each individual institution. Each group in the banking sector, be it the major commercial or investment banks, the credit unions, the savings banks, the private banks or the Landesbanken, will all need to identify their unique impacts and respond accordingly to this legislation. Implementation efforts will depend on the customer data and corresponding onboarding and data storage systems landscapes as well as on the number of countries where these institutions conduct business. Solutions, in turn, will depend on the type of business, for example retail businesses will require different solutions to their impacts than the private wealth or investment banking business in many cases, and the treasury function, with their hedging counterparties, should not be overlooked in this analysis.

Subject to certain requirements regulated funds should be able to push most of the compliance burden to their banks or distributors. The non-regulated, closed-end, fund industry would be caught under FATCA and will have its unique issues to contemplate, including amendments to fund agreements and consideration of the effects of local legislation on reporting requirements. Under the new definitions of an investment entity under the Model I IGA, service providers may be included in the scope of FATCA which may result in these providers being compelled to meet the identification and reporting requirements on their own level.

For the insurance sector, the negotiations around Annex II of the IGA are of particular importance. Annex II of the Model IGA is where non-reporting institutions and products specific to that jurisdiction would be agreed-upon with the US Treasury and explicitly defined. The question of whether an insurance company will be in scope of FATCA requires a detailed analysis of its products. Only insurers with qualifying products will qualify as FFIs under FATCA. Casualty and property insurance companies should, therefore, remain outside of the scope of FATCA since these seem to be unlikely vehicles for tax avoidance. As a number of German insurers maintain international operations or are part of international insurance groups, corresponding FATCA projects require a fairly comprehensive analysis of their business.

Although Germany has not yet finalised or released its IGA with the US, based on the IGAs released by the UK, Denmark and Mexico, one would not expect variances from the body of the agreement and would expect to see Annex II, where non-reporting institutions and products would be described, to be used to address products and institutions particular to the German market and which should be treated specifically under the IGA to be deemed-compliant, exempt or otherwise. Clearly, it is expected that German governmental organisations, the German Central Bank (Deutsche Bundesbank), and branches of international organisations such as the IMF, and certain retirement funds should be considered exempt beneficial owners.

It is further expected that deemed compliant status will be offered to banks focusing on local clients and operating with a fixed place of business only within the borders of Germany, although clients will likely be considered EU-wide with the foreseen threshold to meet the requirements being 98% of the customer-base being resident in the EU. The treatment of holding companies will likely also be addressed to ensure proper treatment of these entities within the legal structures of the financial institutions themselves and with relation to client and/or counterparties.

Within the asset management industry, one should expect that certain open-ended fund structures may be considered deemed compliant in specific cases. Given the market practice in Germany by which clients investing in open-ended funds do so through investor depositary banks, an approach will likely be taken to eliminate this duplicative reporting (at the fund and depositary bank levels). Generally, it is not possible for the fund to identify its beneficial owners. However, since these investments will be made through depositary banks, these banks are well positioned to report on the full value of the assets held in custody, including the open-ended fund investments. Further, it is expected that certain pension and retirement fund investors would not be considered holding financial accounts for reporting purposes which would offer reasonable relief to the managers of institutional funds.

Finally, within the insurance industry, holding companies are expected to be deemed compliant based on the fact that these companies themselves do not offer cash value insurance contracts or annuity contracts. Particular attention will be given to those insurance and retirement products which are subject to penalty and/or tax upon termination and payment as they should be considered exempt since they pose a low risk of tax evasion.

The OECD has a long history of supporting governments in their fight against tax evasion. In particular, the OECD, through its Business and Industry Advisory Committee (BIAC), has since 2006, engaged in discussions for a type of super-qualified intermediary system. The qualified intermediary (QI) system is based on regulations in Chapter 3 of the US Internal Revenue Code and Regulations. It is a clear predecessor to FATCA (Chapter 4 Internal Revenue Code) albeit with distinct differences existing between the two: Whereas the QI system applies only to securities, FATCA applies also to depositary and insurance accounts. QI is optional for banks (from 57 KYC-approved jurisdictions), whereas FATCA is mandatory for all FFIs (thus notably including insurance companies and investment funds).

Since January 2010, the Committee on Fiscal Affairs has expanded the scope of its discussions involving automatic exchange of information to allow for work on a (general) tax relief and compliance enhancement (TRACE) programme. On February 8 2010, BIAC concluded its analytical work with the OECD releasing an "Implementation Package" for public comment.

Under the header of TRACE, negotiations are now taking place which may lead to changes affecting the content of the Final Regulations of FATCA. Since FATCA implementation is becoming more imminent and many governments have started negotiations with the IRS for IGAs, this also gives new political impetus to the idea of a multilateral system of automatic exchange of information as envisaged by TRACE.

From an industry perspective, standardisation or alignment of these initiatives would be preferable but given the approaching deadlines of FATCA (withholding to commence January 1 2014) it is unlikely that FATCA and TRACE will become a unified system. Nonetheless, Germany in particular seems to also consider TRACE as the potential future in the fight against tax evasion while it is becoming less likely that the flat-tax treaty with Switzerland for German offshore accounts will ultimately be signed and the multilateral openness of TRACE offers features which seem appealing politically. For Germany, however, there exist certain treaty-override provisions (specifically § 50d para. 3 Income Tax Act) allowing for automatic relief at source which would constitute a significant diversion away from the current system of mandatory refund procedures (certain exemptions do apply, in particular with respect to the Parent-Subsidiary Directive).

For many countries, execution of an IGA will remain a hot political topic. One consideration is whether the IGA would, by its nature as an international agreement, require 2/3 super-majority consent by the Senate under US constitutional law. German constitutional law will require a domestic law with consent of both parliament (Bundestag) and upper-house (Bundesrat). However, bipartisanship within the various political systems seems to be strong with regard to the fight against tax evasion (however burdensome the system may be) and is attractive to all governments concerned about their budgetary positions.

The impetus for the five European governments to initiate negotiations for an Intergovernmental Agreement was basically two-fold: (i) to receive reciprocal information from the US, and (ii) to address data privacy issues that were raised. Although the issue should have been identified under the QI system, somehow, that predecessor to FATCA managed to be practically applied without data privacy being brought to light as a statutory impediment to implementation.

Under both FATCA and QI, some of the information is reported on an aggregate basis (for example accounts of NPFFI and – in non-IGA-countries – on recalcitrant account holders). However, some of the information is specific to the account holder. While typically public data privacy laws only apply to personal information relating to individuals, the contractual duties of confidentiality apply to both individual and entity (even corporate) clients.

The US is considered an unsafe jurisdiction from an EU data privacy perspective, requiring a higher level of justification (cf. §§ 4b Abs. 2, 4c iVm. 28 Abs. 1 Nr. 2 German Act on Data Privacy) than in the purely domestic context. In particular, without domestic law to implement FATCA, it would remain unclear whether a US Form W-9 does constitute a free and informed (written) consent to use and transfer personal data.

Further, from a contractual perspective, it is not clear whether FATCA withholding would – without specifications under domestic German law – constitute a breach of contract. The justification that is generally used under German law for German withholding taxes is that such taxes either fulfill proprietary tax duties of the payee or may be treated as a prepayment of taxes payable by the account holder. With FATCA that argument does not hold: For example, while FATCA taxes will be imputable and subject to a specific refund system under § 1474 IRC, in practice, the refund is generally limited to treaty violations. Unlike in a German tax withholding case, FATCA tax may potentially be applied to non-US taxable persons on the mere presumption that they might hide US accounts (prima facie FFI being classified as an NPFFI) or be a US person (for example indicia based on a power-of-attorney to a US person). The refund procedure will be difficult at best, thus withholding of US FATCA tax may from a German tax perspective, and other foreign laws, constitute a breach of contract.

The financial industry in Germany is optimistic that local law will tackle all privacy issues (including the request of US forms or substitute forms, the use of non-mandatory data fields, the screening and transfer of personal data) and contractual difficulties.

From a political perspective such information exchange is welcomed. Considering the ongoing discussions around concluding a tax treaty with Switzerland, TRACE or revising the EU Savings Directive, FATCA will form the future standard of tax information exchange and the corresponding increase of global tax transparency which will continue to expand for the foreseeable future.

Karl Kuepper
		PwC Tel: +49 69 9585 5708 Fax: +49 69 9585 1894 Email: karl.kuepper@de.pwc.com Website: www.pwc.de Karl is a partner with PwC in the financial services tax team in Frankfurt, Germany where he leads the German FATCA practice. He has more than 12 years of working experience in international tax and regulatory fund structuring, transactions, private banking and legal advice (corporate, commercial, M&A transactions, arbitration proceedings). Projects include large scale structuring projects, transactions particularly with respect to US investments as well as ICC arbitration proceedings. Karl is a qualified German tax attorney and holds a PhD in investment tax laws.

Oliver von Schweinitz
		PwC Tel: +49 40 6378 2935 Fax: +49 69 9585 968443 Email: oliver.von.schweinitz@de.pwc.com Website: www.pwc.de Oliver von Schweinitz works as tax adviser/attorney specialised in tax for PwC's financial services tax division. He advises on transactional tax and project tax issues, notably in projects requiring international tax support. Before PwC, he worked for international law-firms on private equity and real estate transactions. He studied at Heidelberg, Sorbonne and Duke (LL.M). He also holds a Master of Law and Finance from Goethe University and is admitted to the New York Bar. His doctorate thesis on tax depreciations has been reviewed by Paul Kirchhof, former Justice to the Constitutional Court. He has also published on US and German capital markets law, notably on rating agencies.

Mark Orlic
		PwC Tel: +49 69 9585 5038 Fax: +49 69 9585 965943 Email: mark.dinko.orlic@de.pwc.com Website: www.pwc.de Mark is a senior manager with PwC in the asset management tax team in Frankfurt, Germany where he is part of the German FATCA practice. He has more than 10 years of working experience in international tax and regulatory compliance with a focus on the US. Before transferring to Frankfurt, he spent his entire career in New York, having also worked internationally during this time. Mark studied Accounting and Philosophy at Binghamton University in New York. He is also a Certified Public Accountant (New York) and a member of the American Institute of Certified Public Accountants.