As bank secrecy breaks down, financial institutions in the region are facing increasing burdens of compliance.
It is called, rather dramatically, ‘the last best chance’ for US citizens; the final opportunity to avoid potential criminal tax exposure by declaring offshore assets and income at reduced penalty rates: the United States’ Internal Revenue Service (IRS) fuelled debate around the world after announcing in February 2011 its second offshore voluntary disclosure initiative (or OVDI) for US taxpayers with undisclosed assets overseas. According to the IRS, this OVDI includes higher penalties than the previous one that ended in October 2009, but ‘offers clear benefits to encourage taxpayers to disclose foreign accounts now rather than risk detection and possible criminal prosecution’.
The language used in response to the second OVDI has been almost as dramatic as the wording of the IRS announcement. International law firm Baker & McKenzie wrote in one of its press releases: ‘For US persons in Asia who have not been fully compliant, this is the time to act… Now is the time… to deal with any historical issues and past problems, and move on.’
Some Americans in Asia may be feeling they have been here before. There was considerable worry in Hong Kong after the 2009 IRS announcement, for example. The territory has long been popular as an alternative offshore financial centre as it is not a member of the Organisation for Economic Co-operation and Development and so not party to any of the Organisation’s tax information sharing agreements. The city has a very well-developed banking infrastructure and it is quick and easy to open a bank account there, while taxes are relatively low. In 2009, many expats with US connections in Hong Kong began to see their home country’s long arm looming and started to realise that America is not as far away as it can sometimes feel over cocktails on a South China Sea junk. But worry faded after it became apparent that the IRS, working with the US Justice Department on criminal prosecutions, was particularly targeting non-disclosure of accounts with financial institutions in Europe. Some of Hong Kong’s thousands of US expatriate workers joined the initiative anyway, while others breathed a sigh of relief.
It seems, however, that things are different this time: the US Justice Department also made its own, well-timed announcement of its intention to increasingly focus on what is believed to be non-compliance in Asia. It is this combination of announcements that seems to justify the emotive language from some law firms.
Financial crisis zeitgeist
Most experts agree that the 2009 move by the IRS, and many of the similar efforts by its counterparts in other Western countries around the same time, was a symptom of the new, post-financial crisis zeitgeist. The public mood had turned against big banking, and bank secrecy was an obvious political target. ‘The financial crisis was a crisis of financial transparency. There was a belief that the abuses that happened in the financial system were due to financial institutions behaving in a way that was non-transparent,’ says Marnin J Michaels, a Baker & McKenzie tax partner who practises out of Zurich.
As a result of this feeling, government regulators began to come under tremendous pressure to show they were making real efforts to crack down, in a pro-active way, on banks’ excesses. ‘It’s hard to do that overnight,’ says Michaels. ‘But regulators can show their effectiveness by showing they are clamping down on undeclared money – and they can do that overnight.’
Voluntary disclosure programmes, or initiatives, quickly became flavour of the month as governments realised that undeclared offshore assets were the perfect target. Tax authorities worldwide made it clear that they would no longer tolerate the use of bank secrecy as a means of tax evasion. The UK had held a tax amnesty in 2007 for those with undisclosed offshore accounts, and in 2009 the Inland Revenue announced its New Disclosure Opportunity – another chance for UK taxpayers with unpaid tax connected to an offshore account to reveal their situation. Almost simultaneously with the moves by tax authorities worldwide, the G20 published a blacklist of what it regarded as uncooperative tax havens. Soon afterwards, various countries agreed to cooperate with foreign tax authorities, and some high-profile Swiss banks promised to put an end to anonymous accounts. Beleaguered governments had been given powerful ammunition to use in reply to their citizens’ demands for an end to excessive banking secrecy.
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Banks, insurance companies and other financial institutions are now finding themselves caught between several proverbial rocks and a very hard place as they deal with competing issues: complying with the demands of local and overseas regulators, staying profitable and keeping their clients happy while encouraging them to comply with the latest disclosure initiatives. This is particularly true in the context of the US, which imposes global taxation on individuals who are deemed US persons.
‘Even though a person is in another country, if they aid, abet or conspire to assist a US person to evade tax, they can be prosecuted,’ says Alan Granwell, a partner of DLA Piper in Washington, DC. As Michaels puts it: ‘You have to put your head in the lion’s mouth to avoid larger problems. The banks need to encourage their clients to participate – if not, the US may get the information from clients who disclose in any event.
‘Regulators can show their effectiveness by showing they are clamping down on undeclared money - and they can do that overnight,’
Marnin J Michaels
Baker & McKenzie
Despite various IRS announcements and other publicity over recent years, Granwell says there is still a lack of general knowledge among US taxpayers overseas of their reporting and filing obligations. This can leave banks wondering how far they should go in actively advising their US-person customers. ‘Sending them a generic letter may be very helpful, but it would have to be very carefully crafted. They wouldn’t want to be seen as identifying any clients as US taxpayers,’ Granwell says.
By playing their part in a customer’s voluntary disclosure, banks would need to hand over a considerable amount of information, including details of relationship managers, when a US-person’s account was opened and by whom, and any contacts between the customer and relationship managers. If a bank does not cooperate with its client’s request to see all the information in the bank’s file, the institution will find itself facing a number of regulatory issues, not to mention potential lawsuits from customers who are unhappy with their bank’s performance.
These burdens, placed on banks by voluntary disclosure programmes, come on top of preparations for the pending provisions of a remarkably significant piece of US legislation – the Foreign Account Tax Compliance Act (Fatca). Joe Field, Asia senior partner of international law firm Withers, calls this combination a ‘one-two punch’ for financial institutions. ‘Although it’s important to distinguish between the tax provisions of voluntary disclosure programmes and the draconian enforcement provisions of Fatca, they are so intertwined that separating them would be making a distinction without a difference,’ he says.
When it comes into force, Fatca will effectively turn banks into overseas enforcers for the US Treasury by obliging them to enquire as to the US-person status of their customers. While the IRS chases after delinquent US persons, Fatca will make it more difficult for those potential tax evaders to avoid detection by asking the banks to disclose details of their US-person customers.
If a foreign financial institution refuses to identify relevant US persons, a 30 per cent withholding tax will be imposed on US-source payments made to those institutions. This tax will also apply to gross proceeds from the sales of securities that could pay US-source interest and dividends as well as to payments of US-source income (even if the US person holds only non-US assets). This could mean taking a significant tax hit even on a loss-making sale of shares.
‘The US Government is taking a carrot and stick approach,’ says Granwell. ‘It’s saying, either supply information because you are the one with the closest relationship to the account holder, or we will hit you with a withholding tax.’
The US-centric nature of the law may also lead to counsel dealing with a conflict of laws, as Granwell explains. ‘Banks are also highly regulated locally. It may not be appropriate to give information, impose a withholding tax, or close an account under local law,’ he says. All this leaves banks faced with some stark choices: comply and face the difficulties and costs of doing so, do not comply and accept the 30 per cent tax, or disgorge any US-person clients or US investments (although banks doing this may still face US tax hits under passthrough rules when doing business with American institutions).
‘Even though a person is in another country if they aid, abet or conspire to assist a US person to evade tax , they can be proscuted’
Those who decide to comply will have to expend considerable time and money in doing so. ‘As counsel representing a bank, my concern would be that there are potential liabilities. Banks will now have to interpret what constitutes a “withholdable” payment,’ explains Robert Q Lee, partner and Shanghai office chief representative of Diaz Reus. ‘If a bank fails to comply, then it is in an untenable position. But if the bank becomes overzealous, it may become liable to its customer for wrongfully withholding a payment.’
Due diligence will also be onerous, and several times more detailed than would otherwise be required under qualified intermediary rules. It will not simply be a matter of a bank ticking a box to say it has asked whether their client is, or has ever been, a US citizen. Banks who decide on the other option – simply shutting out US customers altogether – will not find an easy way out, as they will still have problems related to customer identification: not all US persons will come in to a bank branch waving a dark-blue passport or speaking with an American accent. ‘Some Swiss banks have said they will not invest in the US and not take on any US clients. That’s naive,’ says Field. He gives the example of a Norwegian customer who later has a US-person child or grandchild who invests into the United States, thus creating US connections for the bank.
Asia is home to many thousands of people holding US passports or green cards as an insurance policy against political upheaval. Before Hong Kong was returned to China in 1997, for example, many people, facing an uncertain future, made sure they had their US documentation up to date. That decision may now cost them, and their banks, dearly. ‘In the eyes of the IRS, those people are simply tax cheats although they don’t feel like it,’ says Field.
As a highly populous region, and a popular location for expats, Asia also hosts many who belong to a special category of US person: those who may never have lived in America, or hold a passport, but are automatic US citizens and hence subject to American tax laws. A law passed in 1966 that amended Section 301(a)(7) of the Immigration and Nationality Act 1952 means that children born abroad to a parent who was physically present in the US for ten years or more (at least five of which were after his or her 14th birthday) have US citizenship. Consider the situation of a US citizen who lives in the US until she is 25, marries a Chinese citizen resident in Hong Kong and moves back to Hong Kong with him. They then have two children who are born in Hong Kong and live there, not speaking English and never visiting the United States. ‘Both of those children are US citizens and are as American as Barack Obama or Sarah Palin,’ says Field. ‘They have no requirements to confirm or validate their US nationality.’
If those people are unaware of their status and do not renounce their US citizenship between the ages of 18 and 18 ½, they remain liable to US tax until they do so. ‘If they don’t know that they are American citizens, how is their bank going to be able to tell? If you’re a bank you have to worry about all those unintended US beneficiaries, ’ Field says.
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Specialists agree that these problems may be more keenly felt in Asia due to a relative lack of experience among small and medium-sized banks in dealing with complex international legal issues. ‘Bankers sitting in Hong Kong and Singapore are sophisticated, but they are following their local rules – they are not following US rules,’ says Granwell.
Others add that many Asian banks have not yet started taking voluntary compliance programmes and far-reaching laws such as Fatca seriously. ‘The perception is it’s far enough away that it’s not a problem,’ says Michaels. (The IRS does not consider the distance to be so great – it has opened criminal investigation offices in Hong Kong and elsewhere in the region.) ‘In Asia, maybe a little more than in Europe, there may be less sensitivity to compliance,’ adds Granwell. ‘It’s a question of distance, culture and language issues.’
To mitigate risk, and be as helpful as possible to clients while still complying, analysts recommend bankers’ counsel start the process of getting ready for Fatca by identifying their clients. This may be hard to do as detailed implementing guidance on the Act has not yet been released; despite this, it is clear that the law, as it stands, will be very effective. ‘Fatca is a very elegant piece of law – it really does what it wants to do,’ comments Withers partner Jay Krause, while Granwell calls it ‘the most expansive piece of legislation we’ve ever had, because it applies to the whole world’. Another specialist working on the banks’ side says it could, for the same reasons, be described as ‘one of the worst pieces of legislation to be revealed in recent times’, while yet another calls it ‘a kind of US backward imperialism’.
Annetta Cortez, a risk management expert and managing director with Novantas, even suggests that laws such as Fatca could ultimately backfire on the US administration. ‘This is one more nail in the coffin as to why any foreign institutions would want to get too heavily involved with the US,’ she says.
The US Foreign Account Tax Compliance Act
Fatca is widely regarded as both highly significant and extremely complex. It takes effect on 1 January 2013. Chapter 4 is intended to stop US persons from avoiding their US tax obligations by holding income producing assets with Foreign Financial Institutions (FFIs) or Non-financial Foreign Entities (NFFEs) offshore. The definition of an FFI is very broad, and includes banks and other entities taking deposits, custodians and entities holding financial assets for others, and entities engaged primarily in the business of investing – it will therefore encompass funds.
If an FFI agrees with the IRS to report information on ‘US accounts’, certain income produced through it will be subject to a 30 per cent US withholding tax. An FFI can choose to define a depository account as ‘non-US’ if the average balance was less than US$50,000 in the year before the institution made its agreement with the IRS.
In August 2010, the IRS issued some preliminary guidance on the implementation of Chapter 4 (Notice 2010-60). Draft Fatca regulations are expected by summer 2011, but no date has been given for the issuance of final regulations.
Source: Deloitte and DLA Piper reports
Phil Taylor is a freelance writer and editor. He can be contacted at firstname.lastname@example.org.
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