It's hard to argue with a law intended to eliminate rampant offshore tax cheating, especially in light of estimates that the U.S. loses as much as $100 billion in tax revenue a year because of offshore schemes.
The Foreign Account Tax Compliance Act (FATCA) was enacted last year in the wake of investigations revealing rampant collusion between rich Americans and foreign banks to avoid paying U.S. taxes. The Obama administration pushed for the measure in response to the political uproar over the case against giant Swiss bank UBS, which in 2009 settled U.S. government claims that it helped thousands of wealthy Americans hide their money offshore.
The new law would require foreign financial institutions to provide information about each of their U.S.-owned or -controlled accounts, disclose information to the Internal Revenue Service, and withhold U.S. taxes on these accounts if necessary.
FATCA is proving to be so intrusive that it will likely
prompt many foreign banks and investment companies
to abandon the U.S. investment market.
Former House Ways and Means Committee Chairman Charles Rangel (D-N.Y.) who co-sponsored the legislation before he was censured by the House last December for not paying tax on his offshore investments, said, “This bill offers foreign banks a simple choice: if you wish to access our capital markets, you have to report on U.S. account holders.”
But laws designed to stamp out misbehavior often have unintended consequences. In this case, FATCA is proving to be so intrusive and far-reaching that it will likely prompt many foreign banks and investment companies to abandon the U.S. investment market and chart a new course. Even if many banks decide it’s still in their best interest to maintain access to U.S. investments, there is no guarantee that a law designed to eliminate offshore tax shenanigans by Americans will deter creative tax cheats.
In the spirit of full disclosure, I am a New York tax specialist who has represented a number of foreign banks and institutions covered by the new law. As I see it, the system effectively would force every foreign financial institution, including credit unions, broker-dealers, insurance companies, pension plans, funds, family trusts, and securitization vehicles, to choose whether to join the world that invests directly or indirectly in the United States and accepts the costs and risks of an IRS agreement or an alternative world that invests elsewhere.
Many large banks will be forced to spend a minimum of
$250 million each to contact clients and overhaul
We would almost certainly see the creation of a parallel universe of foreign financial institutions that entirely avoid U.S. investments, and other foreign financial institutions that have incentives to reduce their U.S. investments for competitive reasons. By discouraging investments in the United States, and by imposing costs on financial institutions that choose to invest here, FATCA could raise the cost of capital at a time when we are increasingly dependent on foreign lenders and when our economy is still struggling to recover from the recession.
Already, many large banks have estimated that the cost to them could be enormous – forcing them to spend a minimum of $250 million each to contact clients and overhaul computer systems, according to the European Banking Federation and the Institute of International Bankers, two trade associations. The European Union recently requested formal discussions with the United States because of FATCA's intrusive and costly effect on European financial institutions.
Here’s how the law will work: Beginning in 2013, every foreign financial institution that holds U.S. assets must sign an agreement with the IRS to identify its American customers and other counterparties and report to the IRS all payments it makes to them. If an investor refuses to provide a waiver to local confidentiality laws or refuses to disclose his U.S. tax identification number, the institution must withhold a 30 percent tax on payments to the investor that come directly or indirectly from the United States.
"The impact on the Japanese investment trusts market
would be considerable, and we cannot deny...
disinvestment in U.S. securities..."
Foreign financial institutions that refuse to sign up with the IRS – or prove to the IRS that they have no U.S. customers or other counterparties – are hit with a 30 percent tax on all payments that come from U.S. investments they hold themselves, or from U.S. investments held by participating financial institutions.
Some firms, including Royal Bank of Canada, Aegon, and Standard Life, have said they could live with the new regime if the IRS makes technical changes. However, others have objected strenuously.
"If the current FATCA provisions are to be implemented as they are today," wrote Kazutoshi Inano, chairman of Japan's Investment Trusts Association, "the impact on the Japanese investment trusts market would be considerable, and we cannot deny the negative consequence including disinvestment in U.S. securities by the investment trust management companies and other Japanese financial institutions."
An alternative financial world may develop in which
there is little need to hold U.S. assets or to dea
l with firms that hold U.S. assets.
Also, some financial institutions may not be able to participate, for example because the new regime conflicts with local laws or because of the rule that prohibits participation by a financial institution unless all its affiliated institutions participate.
Think of it. We could end up with a reordered global economy in which larger and more connected firms decide to engage with the IRS, while others like Swiss bank Wegelin & Co., which in 2009 announced its intention to divest of U.S. assets in response to U.S. extraterritorial laws, chart a different course.
If many financial institutions opt out, an alternative financial world may develop in which there is little need to hold U.S. assets or to deal with firms that hold U.S. assets. Participating financial institutions will likely make up for the lost capital flows to the United States, but there may be an additional cost. The formation of an alternative financial world also creates a natural haven for determined U.S. tax cheats. By driving financial institutions away, FATCA may make it more difficult for the IRS to identify their U.S. customers.
Out of a population of over 300 million, some Americans inevitably will hide income and assets overseas. However, the recent investigations have been quite successful in identifying Americans with unreported offshore accounts. The IRS reports that since 2009 it has received nearly 18,000 voluntary submissions by Americans with unreported accounts and that it is using those leads to identify other tax evaders and their facilitators. Also, financial institutions worldwide are revising their policies for dealing with U.S. clients and are implementing specific controls against tax evasion.
The global financial system has adapted to other reporting regimes, and undoubtedly will adapt to FATCA. However, the adjustment costs may be significant. The IRS has many other ways to catch American tax cheats without this risky legislation.
David Moldenhauer is a tax partner with Clifford Chance US LLP and an adjunct professor at New York Law School who specializes in international taxation.