Analysis & Commentary: FATCA A Real And Present Danger

TLP

30 December 2011

Last April, when we surveyed the devastating impact that FATCA (the US Foreign Account Tax Compliance Act) is likely to have on the structure of the international investment industry, we concluded that: 'When the EU - no stranger of course to extra-territorial rule-making with its Savings Tax Directive - expresses concern in public about the reach and complexity of foreign tax and information exchange laws, perhaps it is time to sit up and take notice!'

Although FATCA doesn't come into effect until January 1, 2012, with its registration requirement now deferred until mid-2013, there has indeed been a growing chorus of indignation and concern directed at (the wrong target) the Inland Revenue Service. The wrong target, because only Congress, which was unrealistic enough to pass such a flawed piece of legislation in the first place, can do anything to moderate it; and the chances of a bi-partisan change to FATCA in the next year are about on a level with those of a permanent fix to the AMT.

(For those who have been blissfully ignorant of FATCA until now, a brief run-down of its main provisions and implications is included as a supplement to this piece, at the end.)

Prominent among those complaining to the US about FATCA has been Canada.

Canada is not a tax haven, the country's Finance Minister, Jim Flaherty, said recently, warning that any attempts by the US to rigidly impose its Foreign Account Tax Compliance Act on Canadians would accomplish little.

In a letter to several US publications, Flaherty argued that both Canada and the US share a common value in the fight against tax evasion, with each believing "in fair tax systems where everybody pays their share". He is, however, concerned about the impact FATCA will have on Canadian taxpayers.

Flaherty had previously spoken of his desire to see Canada's financial institutions exempt from the FATCA regulations, arguing that subjecting them to it would result in "unnecessary red tape". In his letter, Flaherty stressed that "FATCA has far-reaching extraterritorial implications. It would turn Canadian banks into extensions of the IRS and would raise significant privacy concerns for Canadians."

He was clear that "people do not flock to Canada to avoid paying taxes", and that, with a tax information exchange agreement already in place, there is an existing way of addressing tax issues. There is, therefore, already a system that works. As a result, Flaherty is clear that "to rigidly impose FATCA on our citizens and financial institutions would not accomplish anything except waste resources on all sides".

The probable wastefulness of FATCA is actually one of the main themes of the criticism directed at it: the enormous burden of investigation, reporting, paperwork and compliance placed (or attempted to be placed) on foreign financial institutions (FFIs) which have, or may have, US clients either directly or indirectly, via pass-through payments (eg when a fund pays dividends to another fund which itself may have US investors).

'Attempted to be placed', because one of the main types of response to FATCA has, naturally enough, been an attempt to circumvent it on the part of investors. This ranges from an increased propensity on the part of US expatriate citizens to change their nationality, to the formation of groups of FTC-compliant institutions which can legitimately ignore the legislation by not having US clients and trading only with other such institutions. In other words, the legislation actively encourages the exclusion of US investors from international investment flows. This may not have been precisely the result that Congress intended? London-based investment administration provider Ascentric is one among a number of industry names which has decided to bar US clients. Ascentric head of marketing Dominic Ventham says: “There is uncertainty over the legislation but we can no longer accept a US person on the platform.” The firm says it is reviewing the position of the 50 US clients it already has.

Dan Mitchell, from the Center for Freedom and Prosperity, has written that FATCA “has created a giant nightmare for all sorts of people and firms – including foreign financial institutions that may now decide that it’s no longer worth the trouble to invest in America.” He added that “some non-US asset managers and banking groups are debating whether they could simply ignore FATCA by creating subsidiaries that never touch US assets at all.”

“Many people,” he continued, “when hearing about foreign banks resisting demands by the IRS, might automatically assume the issue involves jurisdictions with strong human rights laws with regards to financial privacy, such as Switzerland or the Cayman Islands …but American tax law has become so bad that the IRS is causing headaches and anger even in nations with high taxes and weak protection of client data.”

Of course, it is possible to believe, along with the framers of the legislation, that UD100bn of tax is being lost annually because of cheating by US citizens with offshore accounts and that the proceeds of all this extra trouble will be worth the pain; yet recent estimates of the expected 'take' resulting from the legislation, including one from official federal sources, have centred around the USD1bn a year mark, while estimates of the cost of compliance to non-US institutions range from USD10bn a year upwards.

Presumably because of a growing realization that there may be negative results from insensitive application of the legislation, the IRS has been struggling to produce workable guidelines on the timetable it had originally set. They had been promised by the end of 2011, but the only major announcement relating to FATCA in the last few months of 2011 has been that of a new form, 8938 (Statement of Specified Foreign Financial Assets), needing to be filed by in respect of tax year 2011 by US citizens and residents, non-residents who elect to file a joint income tax return and certain non-residents who live in a US territory.

Form 8938 is required when the total value of specified foreign assets exceeds certain thresholds. For example, a married couple living in the US and filing a joint tax return would not file Form 8938 unless their total specified foreign assets exceed USD100,000 on the last day of the tax year, or more than USD150,000 at any time during the tax year.

The thresholds for taxpayers who reside abroad are higher. For example, a married couple residing abroad and filing a joint return would not file Form 8938 unless the value of specified foreign assets exceeds USD400,000 on the last day of the tax year, or more than USD600,000 at any time during the year.

Instructions for Form 8938 explain the thresholds for reporting, what constitutes a specified foreign financial asset, how to determine the total value of relevant assets, what assets are exempted, and what information must be provided.

It is confirmed that Form 8938 is not required of individuals who do not have to file an income tax return, but that the new FATCA filing requirement does not replace or otherwise affect a taxpayer’s obligation to file an FBAR (Report of Foreign Bank and Financial Accounts).

Failing to file Form 8938 when required could result in a USD10,000 penalty, with an additional penalty up to USD50,000 for continued failure to file after IRS notification. A 40% penalty on any understatement of tax attributable to non-disclosed assets can also be imposed.

In a recent speech, Douglas H. Shulman, the Commissioner of Internal Revenue, referred to the concerns being expressed to the IRS, which fell into two main categories - the conflict between FATCA and other countries’ laws, and the difficulty in implementing and administering the withholding requirements for pass-through payments and the potential burden they place on foreign financial institutions.

Shulman confirmed that “we have taken these conversations very seriously and you can expect new proposed regulations from us soon after the new year that take into account the implementation concerns we have heard.”

The problems facing the IRS in relation to FATCA are in fact very extreme, ranging from the increased load of bureacracy (estimates of the number of non-US financial institutions 'caught' by FATCA range from 100,000 to 700,000) to the probable adverse reaction of foreign governments. So far these have been muted, due to the extended time-scale, and the hope (on both sides) that negotiation will find a way through. But the IRS does not have much wiggle-room; the legislation is quite clear. So it can be expected that as 2012 progresses, foreign governments will respond to the agonized cries of their finance industries and will turn from fruitless negotiation to considering active measures against the impact of FATCA. At the simplest, these could include a straightforward refusal to allow investment institutions to comply, on the grounds that it would break data protection laws (this path is being actively considered by Brussels). There are many much more aggressive possibilities, including the passing of legislation to impose mirror-requirements on US financial institutions.

Seen from that perspective, FATCA takes on the appearance of being a piece of protectionist legislation. Perhaps that was not the explicit intention of Congress, but that will be the result, unless the law is changed. And what could be more negative than that?

FATCA Briefing

Foreign bank account reporting for US citizens was substantially expanded under proposals issued in October 2009 which became law as part of the HIRE Act in March, 2010. The Foreign Account Tax Compliance Act (FATCA), as it is known, blended proposals included in President Obama’s 2010 budget as well as Senator Carl Levin's 'Stop Tax Haven Abuse Act' and draft legislation published by Senate Finance Committee Max Baucus earlier in the year. Under the law as passed, foreign financial institutions, foreign trusts, and foreign corporations will be forced into providing information about their US account holders, grantors, and owners. FATCA imposes a 30% withholding tax on payments to foreign financial institutions (FFIs) and other entities unless they acknowledge the existence of offshore accounts to the IRS and disclose relevant information including account ownership, balances and amounts moving in and out of the accounts. Among other rules, the legislation requires US individuals and entities to report offshore accounts with values of USD50,000 or more on their tax returns, and mandates electronic filing of information reports about withholding on transfers to foreign accounts. Advisors who help set up offshore accounts have to disclose their activities or pay a penalty.

Under the new law, FFIs must enter into agreements with the US Internal Revenue Service (IRS) to supply various pieces of information about US account holders, including the name, address and taxpayer identification number (TIN), and, in the case of any account holder which is a US-owned foreign entity, the name, address, and TIN of each substantial US owner of such entity. The account number is also required to be provided, together with the account balance or value, and the gross receipts and gross withdrawals or payments from the account. Failure to disclose such information places an obligation on non-US financial intermediaries to withhold a 30% tax on US-source income. These provisions are generally effective for payments made after December 31, 2013, and apply to any US resident who holds more than USD50,000 in a depository or custodial account maintained by an FFI.

Time will tell how much FFIs will have to pay as a result of the administrative changes brought about by the FATCA, but the European financial industry has estimated that the costs of modifying their IT systems, and the administrative burden of ensuring compliance with it, would be significant, and is likely to run into billions of euros. But it is not just foreign banks and other financial institutions that will be affected by FATCA. Investment funds (including hedge funds, mutual funds and private equity funds), insurance companies, and real estate companies will all need to comply with the law, as will all US companies making payments to non-US persons.

The United States Treasury Department and the Internal Revenue Service (IRS) subsequently issued a notice announcing plans to phase in the requirements of FATCA. An FFI must enter an agreement with the IRS by June 30, 2013, to ensure that it will be identified as a participating FFI in sufficient time to allow withholding agents to refrain from withholding beginning on January 1, 2014.

Withholding on US source dividends and interest paid to non-participating FFIs will begin on January 1, 2014, and will be fully phased in on January 1, 2015. Due diligence requirements for identifying new and pre-existing US accounts will begin in 2013, and reporting requirements will begin in 2014.

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