U.S. Tax Laws Change The Rules Of The Game

Ken Harvey & Pierre Noel - Forbes

Most advanced economies have tax evasion problems just as significant as those in the U.S., and it may be only a matter of time before other major countries begin to adopt similar legislation for offshore compliance regimes.

In March 2010, U.S. President Barack Obama and Congress enacted a game-changing piece of extraterritorial legislation--the Foreign Account Tax Compliance Act (FATCA)--as part of increasing efforts to reduce offshore tax abuses by U.S. citizens and residents.

When Obama's pen added Sections 1471 through 1474 to the Internal Revenue Code, financial executives could be forgiven for ignoring yet another addition to America's enormous and arcane body of tax law. But it is more than that; FATCA is an extra-territorial regulatory regime that enlists non-U.S. "financial institutions" in the tax collection efforts of the U.S. government.

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Perhaps not coincidentally, when spoken, FATCA sounds a lot like "fat cat", a word President Obama used to describe wealthy U.S. persons who were illegally avoiding their tax obligations. It all began with the revelations of the "Swiss Banking Scandal" where it was revealed that, allegedly, many wealthy Americans were stashing funds in unreported and therefore tax-evading accounts offshore in places like Switzerland, the Cayman Islands, Singapore and Hong Kong. The use of "secret" offshore bank accounts was surprisingly common. As details of the scandal emerged, financial services practitioners were astounded at the scope of the tax evasion that was apparently occurring. 

The U.S. public, engaged at the time in a rancorous debate of its own regarding the wealthy and taxes, were not amused. Congress and the President swiftly concluded that the current U.S. tax regime--which relies on self reporting of income and assets--was not sufficient to deter "fat cats" with the resources to hire helpful foreign bankers to invest their funds in secret offshore accounts. Something else was needed. The diabolical genius of FATCA is that it more-or-less forcibly enlists those very same foreign bankers in collecting the information the U.S. government needs to find all that money.

Essentially, a "financial institution" must sign a contract with the U.S. Internal Revenue Service (IRS) to identify any U.S. account holders and report them and their accounts to the IRS. In this context, a U.S. account holder is any U.S. citizen, resident, or a non-financial company with meaningful U.S. ownership. The institution must impose a 30% tax on payments or money transfers to any recalcitrant account holders who refuse to identify themselves, and to eventually close such accounts. 

It makes little difference if the institution in question has neither U.S. assets nor U.S. customers. Since any institution doing business in the U.S. will be required to comply, any institution doing business with any complying bank will need to comply as well, and so on. The definition of "financial institution" is also rather broad. Besides including the obvious suspects--banks--financial institutions include investment funds, insurance companies, pension funds, mutual funds, broker dealers, and private equity funds. Virtually anyone who handles or invests money for someone else is implicated.

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Organisations therefore need to consider the business implications of FATCA and of both the cost of compliance and of non-compliance. For foreign financial institutions, the most significant consideration is whether to comply with or attempt to avoid FATCA. Complying with FATCA may require revamping existing procedures such as KYC/Anti-Money Laundering (AML) and adjusting their underlying IT infrastructure. It means changing the way new customers are approved and documented. It also involves the daunting task of delivering the news to the existing customer base and asking them whether they are American citizens or residents and whether they will agree to have their personal details and account information communicated to U.S. tax authorities. 

Attempting to avoid FATCA means either reducing the exposure or limiting the impact. Reducing exposure requires ceasing doing business with U.S. citizens, residents or U.S. corporations’ altogether. This will not, however, eliminate the requirement that the organization document its policies and contract with the U.S. government to be audited in order to prove its compliance with these policies. 

Limiting the impact of FATCA may mean divesting any assets or operations in the U.S., and presumably, no longer being subject or having it’s customers subject to the 30% withholding tax. However, as long as the foreign financial organisation does business in U.S. dollars and has to transact with U.S. banks or with any international bank that is FATCA compliant, these correspondent banks may be instructed by the U.S. federal government to stop accepting business from institutions that are not FATCA compliant. In other words, non-compliance may not be possible for many institutions. 

Resolving the issues FATCA creates may be especially difficult in Asia, where attempting to obtain the necessary documentation is likely to be challenging--and annoying to customers. 

Despite the apparent extra-territorial overreach of the legislation, it seems unlikely that non-U.S. governments are going to make any serious attempt to intervene with the U.S. government to put an end to FATCA. Most advanced economies have tax evasion problems just as significant as those in the U.S., and it may be only a matter of time before other major countries begin to adopt FATCA-like offshore compliance regimes. To this end, the U.S. government and the OECD are already considering the development of future multi-national standards. 

FATCA may therefore lead to the end of banking secrecy as we know it, particularly if global reporting standards are eventually adopted. Financial executives should, accordingly, act quickly to identify the affected operational areas and determine the extent of potential FATCA compliance issues, as the law has significant implications across the business spectrum--for operations, IT, risk and tax.

Pierre Noel is Director Advisory, Head of FATCA services and Ken Harvey is a Partner in the International Corporate Tax Services Group at KPMG China.