The US Will Make Foreign Banks Tax Expatriate US Investors

Jeremy Hetherington-Gore, Tax-news.com, London

07 July 2000

The Internal Revenue Service (IRS) is moving forward in its pursuit of expatriate American citizens who don't pay their taxes. It is usually a surprise for non-US citizens to discover that the US taxes the world-wide income of its citizens wherever they are. Americans who see this as unreasonable - and there are many of them - have two choices: cheat, or give up their citizenship. According to the IRS, a high proportion of the millions of American citizens who live abroad are cheating, and the IRS has announced a series of measures this year to thwart them, involving improved detection techniques, heavier penalties, and new rules for institutions involved in making investments for expatriate US citizens.

It's the last of these that is a particular concern not just to US expatriates but also to the banks and funds which serve them. Under a new US withholding tax regime which comes into force on 1st January 2001, foreign institution making US investments (eg stocks and shares, bonds, fund units, real estate) on behalf of a non-resident US citizen must impose US withholding tax on the income from those investments on behalf of the IRS.

At first glance this may seem extra-territorial, and unenforceable, but think again. There is scarcely a bank in the world that doesn't have financial relationships with US financial institutions, and the IRS is intending to punish errant intermediaries by applying sanctions to their US assets, transactions or counter-parties. This the IRS now has power to do, and it is frightening.

The administrative burdens of applying the regime described by the new regulations are indeed enormous, and indeed possibly unworkable, but that won't be of much comfort to those who face penalties. So how will the new system work?

A foreign institution which makes US investments on behalf of a US citizen can apply to become a 'Qualified Intermediary'. This means that it has in effect a contract with the IRS whereby it undertakes to 'know its customer' and to collect the withholding tax in appropriate cases. But this status is available only to institutions in countries which the IRS has approved as having acceptable 'know-your-customer' rules. Currently, Belgium, Canada, Denmark, France, Germany, Ireland, Italy, Japan, Luxembourg, the Netherlands, Singapore, Spain, Sweden, Switzerland and the UK are thought to be in the running for approval. Institutions in countries which aren't approved (including of course almost all tax havens) will have to supply a list of their US investors and customers with details of their investments. Either way of course the IRS gets to know about all an institution's US customers.

Despite the extreme complication of operating the new scheme, which will cause an extended period of chaos during which illicit flowers will no doubt continue to bloom in reasonable safety, the long-term result will be that an institution wanting to avoid disclosure to the IRS can do so only by severing its financial ties with the US. This is scarcely practicable for most banks, although perhaps easier for some offshore funds.

If the IRS succeeds in applying its new rules, which is not guaranteed, it will have moved a long way towards the position now adopted by the EU, that of information exchange between countries on taxable income streams. Meanwhile, financial institutions worldwide face a situation as of next January which is in its way even more complex and threatening than was Y2K at the turn of the millennium.

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