FATCA deduction: Overview, definition, and example
What is FATCA deduction?
FATCA (foreign account tax compliance act) deduction refers to a withholding tax or deduction applied to certain payments made to foreign financial institutions or non-U.S. persons under the provisions of FATCA. The U.S. government enacted FATCA in 2010 to combat tax evasion by U.S. citizens and residents holding accounts and assets overseas. Under FATCA, foreign financial institutions (FFIs) are required to report certain information about U.S. account holders and their financial activities to the Internal Revenue Service (IRS).
In some cases, if a foreign financial institution or a non-U.S. person does not comply with FATCA reporting requirements, the IRS may impose a FATCA deduction or withholding tax on certain U.S. payments made to these institutions or individuals. This deduction is typically set at 30% and is applied to payments such as interest, dividends, and other U.S.-sourced income.
Why is FATCA deduction important?
FATCA deductions are important because they help enforce compliance with U.S. tax laws, ensuring that U.S. taxpayers are not using foreign accounts to evade taxes. The FATCA withholding tax serves as an incentive for foreign financial institutions and non-U.S. persons to comply with FATCA reporting requirements. Without compliance, these parties face a 30% withholding on U.S.-sourced income.
For financial institutions and foreign entities, FATCA deductions are a critical consideration in international transactions. They must ensure compliance with FATCA regulations to avoid the deduction and ensure that their clients or investors do not face unnecessary tax penalties or withholding taxes.
Understanding FATCA deduction through an example
Let’s say a foreign bank in the UK has a U.S. account holder who earns interest on investments in U.S. securities. The bank is required by FATCA to report the account holder’s financial activities to the IRS. If the bank fails to comply with FATCA’s reporting requirements, any payments made to the bank from U.S. sources, such as the interest on the U.S. securities, could be subject to a 30% FATCA deduction.
For example, if the bank receives $1,000 in interest payments, a 30% FATCA withholding tax would apply, reducing the payment by $300. The bank would receive only $700, and the $300 would be withheld by the U.S. government to ensure compliance.
In another scenario, a U.S. citizen who invests in a foreign mutual fund may have to deal with FATCA deductions if the mutual fund does not report their holdings to the IRS. This could lead to the mutual fund paying a FATCA withholding tax on U.S. income earned on behalf of the investor, which would reduce the amount of income the investor receives.
Example of a FATCA deduction clause
Here’s how a FATCA deduction clause might appear in a contract or financial agreement:
“The payee acknowledges that, in accordance with the provisions of FATCA, any payments made under this Agreement may be subject to a 30% withholding tax if the payee is not in compliance with FATCA reporting requirements. The withholding tax will be deducted from any U.S.-sourced income, including but not limited to dividends, interest, and other payments.”
Conclusion
FATCA deductions are a crucial aspect of international financial transactions that help ensure compliance with U.S. tax laws and prevent tax evasion. For foreign financial institutions and non-U.S. persons, understanding FATCA requirements is essential to avoid the 30% withholding tax that could apply to U.S.-sourced payments. By complying with FATCA reporting and disclosure obligations, institutions and individuals can avoid unnecessary deductions and penalties, ensuring smooth international financial dealings.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.