United States regulatory amendments and guidance create a ‘brave new world’

August 2016 | PROFESSIONAL INSIGHT | BANKING & FINANCE

Financier Worldwide Magazine

The US has been increasingly subject to criticism for failing to identify the beneficial owners of accounts and for failing to require its financial institutions to engage in detailed customer identification procedures to identify the beneficial owners of entities at the time of account opening. To counter this criticism, the US commenced several initiatives in the spring of 2016.

First, on 21 March 2016, the board of governors of the Federal Reserve and other regulatory agencies issued inter-agency guidance on applying Customer Identification Program (CIP) to the holders of prepaid credit cards. The focus is on whether an account has been opened or an account relationship exists, since that is the basis for the requirements under the CIP Rules. The guidance explains that general purpose prepaid cards that may be reloaded by the cardholder, or another party on behalf of the cardholder, in a manner that is similar to the way in which funds can be added to a deposit, asset or transaction account is the equivalent of opening an account for purposes of the CIP Rule. By contrast, it notes that a general purpose prepaid card that cannot be reloaded does not establish an account for CIP purposes.

The guidance also provides that general purpose prepaid cards that permit withdrawal in excess of the card balance and allow the cardholder access to an overdraft line or an established line of credit, similar to a lender/borrower or credit card relationship is an account for purposes of the CIP Rules. The guidance further provides that an account is not established until a reload, credit or overdraft feature is activated by a cardholder registration.

The agency guidance then discusses how CIP rules are applied to different types of prepaid cards. The guidance states that the cardholder should be treated as the bank’s customer, even if the cardholder is not the named account holder but has obtained the card from an intermediary who uses a pooled account to fund bank-issued cards. Thus, third-party programme managers should be treated as agents of the bank for purposes of the bank’s CIP rule, rather than as the bank’s customer.

The guidance then notes that in the case of non-reloadable general purpose prepaid cards without credit or overdraft features, or other prepaid cards that do not have the identified features that establish an account for the purposes of the CIP rule, such as closed-loop prepaid cards, the third-party programme manager in whose name the pooled account has been established should be considered the only customer of the issuing bank and only it is subject to the bank’s CIP rules.

The guidance then goes on to deal with payroll cards, government benefit cards and health benefit cards. With respect to payroll cards, if only the employer or the employer’s agent may deposit funds into the payroll card account, the employer should be considered the bank’s customer for purposes of the rule. If the employee is permitted to access credit through the card, or reload the payroll card from sources other than the employer, the employee should be considered the customer of the bank subject to the CIP rules.

With respect to government benefit cards, if the government benefit card permits only government funds to be loaded and does not provide access to credit, a bank that issues a government benefit card is not required to apply the CIP programme since the term “customer” does not include a department or agency of the US. If the card allows non-government funds to be loaded onto the card or provides access to credit, then the relationship is between the bank and the beneficiary-cardholder and the bank should collect CIP information from the beneficiary-cardholder.

With respect to a health savings account (HSA) or accounts established as part of a flexible spending arrangement (FSA), or health reimbursement arrangement (HRA) the rules are again different. With respect to HSA accounts established by an employee to pay qualifying medical expenses, it is the employee who is the bank’s customer for purposes of the CIP rule. With respect to the FSA and HRA arrangements established by the employer, the employer is the customer for the purposes of the CIP rules.

The guidance then provides that, with respect to third-party programme managers, a binding contract should be entered into that outlines the parties’ CIP obligations, ensures the right of the bank to transfer, store or otherwise obtain access to all CIP information collected, provides the bank the right to audit the third-party programme manager and provides that the relevant regulatory body has the right to examine the third-party programme manager.

Second, Treasury issued final regulations with respect to entity reporting for purposes of Form 8938 and IRC § 6038D. The statutory scheme was adopted as part of FATCA and the final regulations provide that certain “specified domestic entities” are subject to reporting of specified foreign financial assets that exceed the reporting threshold under the existing regulations. The regulations note that if the specified domestic entity has an interest that is excluded from reporting on the Form 8938 because it is reported on another form, the exclusion would apply for purposes of determining the aggregate value of the specified foreign financial assets. The regulations define a “specified domestic entity” as a domestic corporation, partnership or trust if the corporation, partnership or trust was formed or availed of for the purposes of holding directly, or indirectly, specified foreign financial assets. For purposes of a corporation and partnership, the regulations define a domestic partnership or corporation as “availed of” for holding foreign assets where the corporation or partnership is closely held, and at least 50 percent of the corporation’s or partnership’s gross income is passive or at least 50 percent of the assets by the corporation or partnership are assets that produce or are held for the production of passive income. For the purposes of this test, the percentage of passive assets held by a corporation or partnership is the weighted average percentage of passive assets (weighted by total assets and measured quarterly) and the value of the assets of a corporation is the fair-market value of the assets or the book value of the assets reflected on the corporation’s or partnership’s balance sheet.

The regulations then define “closely held” domestic corporations, and partnerships. “Closely held” is defined, for purposes of a corporation, as one held by a specified individual if at least 80 percent of the total combined voting power as owned directly, indirectly or constructively by a specified individual on the last day of the corporation’s taxable year. A partnership is considered closely held by a specified individual if at least 80 percent of the capital and profits interest of the partnership is held directly, indirectly or constructively by the specified individual on the last day of the partnership’s taxable year. For purposes of this test, IRC §§ 267(c) and (e)(3) apply, except that IRC § 267(c)(4) is applied as if the family of an individual includes the spouses of the individual’s family members.

“Passive income” is defined as the portion of gross income that consists of dividends, including substitute dividends, interest, income equivalent to interest including substitute interest, rents and royalties (other than rents and royalties derived from the active conduct of a trade or business conducted at least in part, by employees of the corporation or partnership), annuities, the excess of gains over losses from the sale or exchange of property that gives rise to passive income, the excess of gains over losses from transactions in any commodity with certain exceptions, the excess of foreign currency gains over losses and net income from notional principal contracts. There is an exception from the passive income rules when the corporation or partnership acts as a dealer in property if the transaction is entered into in the ordinary course of such dealer’s trade or business and if the dealer is a dealer in securities if the transaction is entered into in the ordinary course of the trade or business.

The regulations further provide all domestic corporations and partnerships that are closely held by the same specified individual and are connected through stock or partnership interest ownership with a common parent or partnership are treated as owning the combined assets and receiving the combined income of all members of the group. A domestic corporation or partnership is considered connected through stock or partnership interest if the stock represents at least 80 percent of the total voting power of all classes of stock of the corporation or partnership interest of at least 80 percent of the profits, interest or capital interest of such partnership is owned by one or more other connected corporations, partnerships or common parents. With respect to domestic trusts, reporting is required if the trust is formed or availed of for purposes of holding, directly or indirectly, specified foreign financial assets if the trust has one or more specified persons as a current beneficiary. A “current beneficiary” is defined as any person who at any time during the taxable years is entitled to, or at the direction of any person, may receive a distribution from the principal or income of the trust and includes the current holder of any general power of appointment whether or not exercised but does not include any holder or a general power of appointment that is exercised only at the death of the holder.

Third and most importantly, on 11 May 2016, the Treasury issued long-awaited customer due diligence (CDD) regulations for financial institutions. There were major changes made to the initially proposed regulations in coming to the final regulations and, because of the dramatic changes and the expense and implementation costs associated with these regulations, they will not be effective until May 2018. Covered financial institutions under the amended regulatory framework must identify and verify the identities of beneficial owners of all legal entity customers at the time a new account is opened. The second major prong of these regulations is an amendment to anti-money laundering (AML) programme requirements. Covered financial institutions include banks, brokers or dealers in securities, mutual funds and commodity commission merchants, and introducing brokers in commodities. The AML programme requirements for each of these categories has been amended to include risk-based procedures for conducting ongoing consumer due diligence, which includes understanding the nature and purpose of the relationships for the purposes of developing a risk profile for each customer at the time of account opening.

The beneficial ownership regulations provide that, with respect to legal entity customers, the due diligence procedures shall enable the institution to identify the beneficial owners of each legal entity customer at the time the account is opened (unless subject to exemption) either by using a certification form or obtaining information required by the form by another means. The regulations include a draft self-certification form that can be employed at account opening. The institution must verify the identity of each beneficial owner according to risk-based procedures. The procedures must include customer verification (which already existed in the regulations), and may rely on copies or reproductions of the required documents supplied by the entity provided that the financial institution has no knowledge of facts that would call into question the reliability of the information being provided. For purposes of the rule, a beneficial owner is each person who directly or indirectly owns a 25 percent or more equity interest in the legal entity. Importantly, the rule contains a second tier of identification and requires the identification of a single individual with significant responsibility to “control, manage, or direct a legal entity customer”. This may include a chief executive officer or senior manager or any other individual who performs similar functions. The regulations provide that if a trust owns, directly or indirectly, 25 percent or more of the interest in the entity the beneficial owner shall mean the trustee.

A legal entity customer “means a corporation, limited liability company, or other entity that is created by the filing of a public document with a Secretary of State or similar office, general partnership or any similar entity formed under the laws of a foreign jurisdiction that opens an account”. There is a series of exclusions for regulated financial institutions, publicly traded companies and the like. The exempt accounts include: (i) at the point of sale products to provide credit products, including commercial private label credit cards employed solely for the purchase of retail goods or services at these retailers up to a limit of $50,000; (ii) accounts to finance the purchase of postage, or the payments which are remitted directly to the provider of the postage products; (iii) accounts to finance insurance premiums for which payments are remitted directly to the financial institutions, and (iv) accounts to finance the purchase or leasing of equipment for which payments are remitted directly to the vendor or lessor. Records must be retained for five years after the account has been closed and a covered financial institution may rely on the performance of another financial institution if such reliance is considered reasonable under the circumstances and the other institution is subject to the Title 31 regulations or enters into a contract to certify that it has implemented an AML programme and will perform the specified requirements to comply with the requirements of the regulations.

The AML regulation amendments, which impose substantial additional burdens, change the minimum requirements of an AML programme adding a new provision. The amended AML regulations require for any programme “appropriate risk-based procedures for conducting ongoing customer due diligence”. These procedures must include, but are not limited to, an understanding of the nature and purpose of customer relationships for purposes of developing a customer risk profile, conducting ongoing monitoring to identify and report suspicious transactions and, on a risk basis to maintain and update customer information. These are significant changes which commentators and others will have additional time to analyse and review with the two year delayed implementation date but these will require, as seen above, a risk-based programme, risk-based monitoring and risk-based profile for every new account opened by a financial institution. FinCEN, however, did make it clear that these amendments apply only to new accounts and that retroactive application is not required. The accumulation of the amendments above, plus the new rules with respect to customer due diligence and AML programmes, certainly combines to bring a ‘brave new world’ for these covered financial institutions in the US.

Ian M. Comisky is a partner at Blank Rome LLP. He can be contacted on +1 (212) 569 5646 or by email: comisky-im@blankrome.com.

Ian M. Comisky

Blank Rome LLP