FATCA: Be Careful What You Wish For

When the US Congress passed the Foreign Account Tax Compliance Act (FATCA) in March 2010, it unleashed on the world in the blink of an eye what many see as a politically-motivated and ill-thought-through behemoth.

Since then, the US Treasury (UST) and Internal Revenue Service (IRS) have been back-pedalling, timeframes have slipped significantly and bi-lateral work-arounds are being engineered with the US government in order to reduce the pain for the financial services sector and its users. At the same time, however, the bandwagon rolls on and the political capital to be gained from the ‘sons’ and ‘daughters-of-FATCA’ has won plaudits in various nations’ government circles (keen to increase tax take in continuingly difficult economic times.)

What does this mean for the international financial services industry and will FATCA really make a difference to the good?

FATCA: A Brief Overview

Through FATCA, the US is attempting to outsource the work of tax enforcement, not only to the private sector but to financial firms in all jurisdictions. In essence, FATCA requires financial institutions to withhold 30 per cent tax on income from US sources unless the firm is sure that the payee is not a US taxpayer. To put it another way, retail banks, investment banks, custodians, mutual funds, other investment entities such as hedge funds, wealth mangers, brokers and some insurance firms need to be able to identify which, if any, of their customers or investors are US persons and, crucially, will have to report that information to the IRS. Financial firms across the globe face becoming tax or information collectors for the USand, if current trends continue, for other nations too, while client take-on procedures are made increasingly complex.

For financial firms of any size, the implications in terms of internal procedures and information technology requirements are sobering. For a start, client on-boarding, due diligence and monitoring procedures will require attention to ensure that the information required by FATCA is obtained. Current clients or investors will need to be reviewed – no mean feat in itself, even before complex aggregation and documentation rules are considered. Firms will also need to pay attention to procedures for determining the FATCA status of payees and, where necessary, imposing withholding tax on payments. That tax revenue will need to be remitted to the IRS, and even where there is no withholding, financial firms will also need to establish and maintain systems for the periodic reporting of information to the IRS. Add to this the obligation in perpetuity to re-certify FATCA compliance, andit is no surprise that FATCA has created a global mini-industry in its own right.

“We Want Information”

Surprising as it might seem, however, the UST professes that its primary motivation is not tax revenue but information on US taxpayers. That is probably a good thing as FATCA’s withholding tax provisions are among its most complicated and most onerous sections for non-US financial firms to follow. This situation paved the way for the development of bi-lateral ‘Intergovernmental Agreements’ (IGAs) between the US and ‘FATCA partner’ jurisdictions professing commitment to the objectivesof FATCA but ready to find a more practicable means of compliance. Although potentially a recipe for disaster with any number of different IGAs being arranged, each with different definitions, different reporting requirements and different timeframes, a modicum of sanity has prevailed in the form of model IGAs. Crucially, the IGAs essentially eliminate the requirement to withhold on ‘recalcitrant’ (non-cooperative) account holders or investors and, very importantly, by involving domestic tax authorities in the reporting process, moves a long way towards overcoming data protection, privacy and confidentiality restrictions, which might otherwise have prevented firms from being able to comply with FATCA. Definitions and timeframes have also been largely aligned between the model IGAs and the FATCA regulations.

It is also to be welcomed that, in a further move to avoid country-to-country differences as far as possible, the UK’s approach to implementation of the UK/US IGA is expected to form the basis for most or all other nations’ implementation.The UK’s HM Revenue & Customs (HMRC) is currently working hard, in consultation with all sectors of the UK financial services industry, to find a sensible approach to dealing with this legislation imposed from afar. Meanwhile, it is not even clear that the IRS has truly welcomed FATCA, and how it copes with the administrative burden, let alone the gargantuan volume of data that will be delivered under FATCA, remains to be see. While the extensions granted by the UST to key deadlines have been touted as being in response to industry representations, one cannot help but believe that the IRS was also not disappointed.

Of course, there is a quid pro quo for HMRC and its peers: the most popular model IGA so far has been that which promises reciprocity, namely that the IRS will collect and provide to the FATCA partner tax authority details of that country’s residents holding accounts with US financial firms.

The Lesser of Two Evils

The focus on reporting of information rather than tax collection, on the one hand,and the globalisation of the financial system on the other,play into the IRS’ hands, making it harder and harder for financial firms not to comply with FATCA or an applicable IGA. Essentially, the more financial institutions who comply, the harder it will become not to comply; participating firms will find it easier and more efficient to deal with other participating firm, whether as clients, as investors, as counterparties, as custodians or as recipients of investment capital, with the alternative being the risk of suffering withholding tax, or the aggravation of having to deal with non-participants or recalcitrants.

Being the lesser of two evils does not, of course, make something popular. Unsurprisingly, FATCA has led to an outpouring of anti-US commentary from foreign financial firms and industry practitioners, and also from US sources. Some fear that inward investment will be discouraged while others such as US senator Rand Paul see it as an unwarranted attack on personal liberty and privacy. A minority of US non-doms have even gone so far as to renounce their US citizenship.

Sons and Daughters

It may be that the primary impact of FATCA and the related IGAs will be to have generated significant amounts of work for consultants and IT professionals, thus boosting their income and tax liabilities wherever in the world they may be. Nevertheless, there is one constituency from which FATCA has received a far warmer reception: foreign governments.

The US is almost unique in its citizenship-based tax regime which lends itself to FATCA as US citizens cannot escape the IRS by hiding abroad and ‘all’ the IRS needs is information on where to find them and their assets. While the same is not true of residency-based tax systems, there may still be value in tax authorities knowing where their residents’ assets reside. Meanwhile, the global economic downturn forced many governments to impose unpopular austerity measures and yet economies stubbornly refuse to show more than a few green shoots. Any option for deficit reduction is therefore pounced upon. Increasing tax take has become a focus of attention, with the line between avoidance and evasion blurred almost to extinction. In May 2013, HMRC, the IRS and the Australian Tax Office announced an agreement to share data on trusts and corporate structures, and their advisors, putting more scrutiny than ever on transfer pricing and the movement of profit between countries. Whatever one’s views on the seemingly inexorable trend towards a principles-based tax regime, most politicians can only welcome measures promoting international tax transparency and the promise of information about potentially undeclared assets.

So it is that recent months have seen a resurgence in agreements to collect and share information. The UK has entered into FATCA-style agreements with its Crown Dependencies to collect information on UK taxpayers’ assets parked offshore. The comments of Guernsey’s Chief Minister, Peter Harwood, in May 2013 that Guernsey “strongly supports the rapid adoption of FATCA-type multilateral automatic information exchange as a new global standard” are typical among European government ministers. At the G7 meeting in the UK the same month, UK, French and German ministers supported the principal of legislation to fight tax evasion in the EU, which sentiments came hard on the heels of five European governments in April 2013 expressing an intention to create a European FATCA-style arrangement. Further afield, in the summer of 2012, the UK Parliament’s International Development Committee (IDC) also recommended that UK adopt FATCA-style legislation, encouraging others, including developing nations, to follow suit.

The US and other major financial or industrialised nations may well be able to get away with such intrusive and costly extra-territorial measures but less robust economies risk deterring the very inward investment which they need. In practical terms, unless definitions and timescales are aligned, which is far from certain, the proliferation of FATCA-style legislation would spell confusion and uncertainty for financial firms everywhere attempting to remain compliant with ever-changing rules.

The Value of Consensus

It may be that, in a decade’s time, we will see a globally-accepted regime of tax transparency, and many politicians and taxpayers would argue that that would be a good thing. But is the FATCA bull in the financial china shop the way to get us there?

Perhaps the closest thing we have to global regulation is that surrounding anti-money laundering and, more recently, countering the financing of terrorism (AML/CFT). Growing out of the fight against drugs trafficking in the 1980s and early 1990s, a consensus emerged among governments in the developed world that money laundering should be outlawed, and hence that an AML regime was desirable. As early as 1990, the inter-governmental Financial Action Task Force (FATF) issued The Forty Recommendations (the FATF 40) to assist governments in tackling money laundering. Over time the FATF 40 were revised and refined, and in 2001, nine Special Recommendations for CFT were added. Further revisions followed and in February 2012 the FATF 40+9 were consolidated into a new 40-strong list. The FATF’s recommendations formed the basis for mutual evaluations and the identification of non-cooperative territories and countries (NCCTs) whose AML regimes were found to be inadequate. Miscreant jurisdictions with poor AML controls, including many offshore financial centres and developing nations, were consciously sidelined and occasionally sanctions were imposed against significantly-deficient jurisdictions as a means of applying pressure on them to improve. Although the NCCT programme was discontinued in 2006, for over two decades the FATF has existed as the embodiment of international AML consensus.

That consensus led governments across the developed world to draft and enact AML legislation on broadly similar terms, consulting extensively with the industry on the legislation itself, its implementation and interpretation. The concept of ‘equivalence’ between jurisdictions gained currency, becoming the closest thing we have to a common regulatory approach. The global thrust received a boost following the 9/11 terrorist attacks, after which the US began to back AML/CTF like never before. As the focus of AML evolved from drugs to other crimes, including tax evasion, to terrorist funding, the scope of the regulated sector also grew. Originally applied to banks, over time AML/CFT rules spread to include other ‘gatekeepers’ such as lawyers, accountants, realtors and dealers in high value goods.

That is not to say that the AML/CFT regime is now flawless; far from it. There remain serious cost-benefit questions as to whether AML/CFT rules actually prevent money laundering or the financing of terrorism, and firms continue to fail spectacularly in their AML/CFT delivery. Nevertheless, the consultative and iterative approach gave the industry and, importantly, the clients and investors a chance to become accustomed to the key concepts, rather than it becoming a deterrent to business or a competitive issue between jurisdictions or firms.

A global consensus has made it hard to argue that the regime should be dismantled. So it may turn out with FATCA and similar legislation. Global taxpayer transparency may be existentially desirable, but there are ways of achieving it. Unilateral political gestures are not the way, and the financial services industry is now suffering the consequences.