Article in The Nation, March 2, 2012
On February 8, the US Internal Revenue Service issued regulations to help implement a 2010 law geared towards improving the US government's ability to identify its citizens evading tax by hiding assets in foreign accounts.
The law and accompanying regulations are specifically designed to place the burden on foreign financial institutions in making them report information on US taxpayers (whether US citizens, resident aliens or legal entities) and even non-US legal entities with US shareholders. The compliance burden has been criticised by the financial community as onerous and beyond the authority of the IRS, as it reaches into the inner workings of financial institutions everywhere. And yet, the process appears to be moving on apace without any reprieve for financial institutions who find themselves at a loss as to how to comply with the various due diligence procedures mandated. How did we get here?
It was in 2008 when a Swiss bank - at the time, the world's largest private bank - found itself in the middle of a scandal straight out of a spy novel. An American private banker had been caught red-handed trying to smuggle diamonds into the US for private banking clients. He was smuggling diamonds as a means of transporting funds to US citizens that had been secretly stashed offshore and not subjected to US taxation. US taxpayers are subject to taxation on all their worldwide income, regardless of where earned, kept or spent. This bank, apparently, had been helping US citizens hide untallied sums of money from the IRS. It was a good business.
When the US government finally uncovered the fraudulent schemes, it ordered the bank to divulge information on all its US clients. The problem was that the US government ran into a Swiss banking system of secrecy that dated back hundreds of years. In 1934, the Swiss parliament passed the first bank secrecy law making it a crime to disclose bank account information.
When the US demanded that the bank turn over any information relating to US tax citizens, the Swiss government asserted that the bank could not do so under the Swiss banking laws, effectively tying the hands of the US government.
The stage was set for the US to get tough on foreign financial institutions and make them pay a price for assisting US tax dodgers. The US Congress acted to expand the IRS's power and ensure that foreign banks could no longer find it financially beneficial to assist Americans with tax evasion, by passing the Foreign Account Tax Compliance Act (FATCA) in 2010. This Act takes what was a voluntary reporting requirement out of the hands of US nationals with assets in foreign accounts and now places the burden of reporting this information on the foreign financial institutions.
When first enacted, FATCA was quite broad in scope and short on details. It seemed as though all financial institutions would have the incredible responsibility of reporting the details of every single open account, whether held by a US national or not. The compliance burden and associated costs appeared, at first glance, unfathomable, prompting several rounds of back-and-forth with the IRS to reduce the burden, along with threats from several foreign banks that they might stop doing business in the US, altogether.
The IRS listened and, on February 8 this year, issued 388 pages of regulations that appear to address some of the financial industry's concerns. The newly issued proposed regulations, while not yet final, go a long way to providing a roadmap to what the IRS expects of foreign financial institutions. The proposed regulations lay out initial due diligence procedures foreign financial institutions must undertake, along with detailed explanations of ongoing reporting requirements needed to satisfy the IRS's thirst for information.
The US government takes this programme very seriously. The cost of non-compliance by a foreign financial institution is 30 per cent withholding tax assessed on interest and dividend payments from the US and 30 per cent tax assessed on the sales price (not the gain) of securities sold to US persons.
Foreign financial institutions - which can include banks, asset management companies and some insurers - are now on notice as to what is expected. They must now begin the arduous process of modifying their reporting systems to ensure compliance, and quickly, as the deadline to initiate due diligence procedures is 2013. The need for foreign financial institutions to start budgeting and planning for adoption is imperative.
This information is intended as a general guide only. Tax law is complex and professional advice should be taken before acting on the information provided.