How To Operate, When the Feds Step Up Hunt for Tax Evasion Overseas

November 16, 2009
Chris Kentouris

Legislation introduced in Congress last month could help Uncle Sam take in more than $3 billion in extra taxes over the next decade from U.S. investors who would otherwise dodge paying taxes due on foreign income, by the estimate of the Internal Revenue Service.

In the meantime, operations executives at foreign banks and other financial firms will be chalking up plenty of overtime in handling the systems and procedural changes required to comply.

The measure, known as the Foreign Account Tax Compliance Act (FACTA), forces foreign financial entities to sign an agreement with the Internal Revenue Service that they annually disclose the identities of direct and indirect U.S. investors in foreign assets and consent to some type of external auditing. Foreign firms which do not comply with the FATCA must pay the IRS a 30 percent withholding tax on income and gross proceeds the foreign firms are paid not only for their U.S. customers in foreign assets but also their foreign customers in U.S. assets.

“Because of the expansive definition of foreign financial intermediary in the bill, there are a large number of entities that will have to comply with these provisions that have very little existing information reporting expertise and systems and thus will be starting from the very beginning,” said Tom Provost, Americas tax director for Credit Suisse, about the operational impact of the legislation. He spoke before the House Ways and Means Committee Subcommittee on Select Revenue Measures on Nov 5. The definition of “foreign financial intermediary” includes not only banks, but brokerages and offshore hedge funds.

While foreign firms do keep track of the identities of all their account holders they have never previously been required to reveal to the IRS the names of U.S. citizens or companies who invest directly in foreign assets. Nor have they ever had to “look through” the ownership of the account to determine whether a U.S. investor has a ten percent – and in some cases even less -ownership stake in an offshore entity.

The IRS in the past presumed the U.S. investor disclosed any accounts in foreign assets.The new legislation comes after tens of thousands of Americans’ offshore accounts in recent months were shut down by banks under pressure from the U.S. Treasury and requests to open new accounts have been denied.

Switzerland’s financial services giant, UBS, for instance, decided to end offshore banking with U.S. customers in July after admitting that it assisted over 50,000 U.S. citizens in evading U.S. taxes.

The measure, introduced by House Ways & Means Committee Chairman Charles Rangel (D-NY) and Senate Finance Committee Chairman Max Baucus (D-MT) could go into effect as early as January 1, 2011. While considered far less stringent than what the Obama administration had initially proposed in its so-called green proposal in May, the proposed legislation gives banks and other financial firms less than two years to make the necessary changes to their recordkeeping systems and procedures.

Tax operations executives at four other custodian banks contacted by Securities Industry News last week declined to comment specifically on how the prospective legislation would affect their banks’ strategies, but one said that his bank was undergoing a “cost-benefit” analysis of what the new legislation would mean to its profit margin if it declined to accept U.S. investors or decided to comply.

“Foreign financial institutions may decide not to accept accounts of U.S. investors, but that’s not usually a practical business decision,” says Alan Lederman, a tax attorney with Gunster, Yoakley and Stewart in Fort Lauderdale, Fla.

Yet John Staples, a partner with Burt, Staples & Manor in Washington. D.C. countered that the cost of preparing may be so prohibitive that foreign banks will be willing to forgo complying. “The result will be that U.S. tax cheats will have just as many opportunities to evade through offshore accounts,” says Staples. “The only sensible solution appears to be a multilateral approach where countries act in concert to close down this kind of abuse.”

Credit Suisse’s Provost estimated it could take up to 24 months for a foreign firm to properly implement the new requirements after all the relevant rules have been finalized. An operations executive at a Paris-based custodian bank told Securities Industry News that it would cost his bank at least $1 million – and three years – to prepare for the regime. “We may have to install new recordkeeping software to keep track of U.S. investors and train staff on new account opening procedures for U.S. investors,” he said.

According to this operations executive, the legislation in draft form doesn’t provide clear guidance as to how banks should document their U.S. investors. While most banks do have know-your-customer and anti-money laundering procedures in place for foreign investors, it is uncertain whether the IRS will accept such measures for U.S. investors.

One of the most burdensome provisions of the legislation, say tax operations experts, is that it would require a foreign financial institution to track down and report information on direct and indirect U.S. investors in all of the foreign accounts held at all of its affiliates.

A foreign financial intermediary which fails to disclose all of those names will be considered “non-compliant” by the IRS. All payments of income and gross payments paid to the intermediary for both U.S. investors in overseas assets and foreign investors in U.S. assets would then be subject to the 30 percent withholding tax, even if an affiliate was responsible for the error. This penalty will also be imposed even if the foreign financial intermediary has correctly compiled with the IRS policies as a qualified intermediary (QIs).

Banks, such as Credit Suisse, which are accredited as QIs by the IRS– a status permitted since 2001—do not have to report to the IRS the names of foreign investors in U.S. securities. Those 5,000 or so banks have already developed extensive recordkeeping systems to categorize non-U.S. customers into different tax categories and either deduct the appropriate withholding tax themselves or send the information on the investors to yet another bank. That bank, typically a U.S. global custodian, then would deduct the correct tax amount.

But information on the accounts of U.S. investors in foreign assets is typically stored in a separate recordkeeping system, if at all. “The foreign bank would need some kind of customized system to sweep the accounts maintained by affiliates for the names of the U.S. investors in foreign assets and the value of such assets,” said Cyrus Daftary, executive director of Compliance Technologies International, a Boston-based software firm specializing in tax withholding and reporting. Such an undertaking could become difficult because banks often maintain separate recordkeeping systems in their multiple affiliates.

The new measure before Congress does exempt the accounts of U.S. individuals with “low balances” most large financial institutions are unlikely rely on such exceptions because the affiliates must be treated as a single institution when determining whether the account exceeds the threshold. “A financial institution’s computer systems may not provide ready, non-manual aggregation of account balances for a particular individual across various jurisdictions and affiliates,” said Provost in his testimony.

The proposed legislation also does not indicate how and when the threshold is measured. “Must the account balance be below the threshold for each day during the calendar year to qualify, or is it determined only as of the reporting date, or as of some other period such as the average of the closing balances for each month?” he asked.

Provost recommended that foreign firms be exempt from reporting on U.S. investors who are indirect investors -- stakeholders in foreign operating entities that do not engage “primarily in investing, reinvesting or trading in securities or other financial instruments.”

According to Dan Byrne, a tax partner at Rothstein Kass, a Roseland, N.J. accounting firm specializing in hedge funds, offshore hedge funds would likely have to require corporations, partnerships, and trusts that want to invest in the fund to agree to disclose and continually update any information regarding their U.S. investors. In addition, offshore hedge funds would need to closely track direct ownership by U.S. investors to see which U.S. investors cross the 10 percent threshold.”

While many offshore hedge funds have already voluntarily been tracking and disclosing to the IRS U.S. investors which directly own a 10 percent stake in the fund, the requirement to track and disclose information about the indirect U.S. owners is new and will likely be “one of the more burdensome aspects of the legislation for offshore hedge funds,” said Byrne.