US Tax Legislation Targeting Customer Relationships Heralds a New Era of Information Exchange

Governments around the world believe that tax evasion is widespread and that every country has a right to information about its own taxpayers. Well-publicised tax evasion scandals have affected a number of countries and there is an increased focus on offshore financial centres resulting from the global economic downturn. As a result, tax havens, the need for customer transparency and the implementation of information exchange agreements are high on political agendas.

Significant increases in the value of cross-border transactions resulting from the globalisation of financial systems have given taxpayers greater freedom to move income and assets across national borders. With this freedom comes an increased risk of tax evasion.

For more than 15 years, the Organisation for Economic Co-operation and Development (OECD) has worked towards better transparency and information exchange for tax purposes with the intention that taxpayers cannot hide their income and assets, and that they pay the appropriate tax in the correct jurisdiction. Tax authorities themselves have increasingly pursued the free and accurate exchange of information as the means to ensure the proper application of their tax law. For this approach to be successful and timely, the exchange of information must be automated.

Companies and individuals need to start dealing with this changing climate where proactive information exchange is becoming increasingly prevalent. There are now 511 bilateral tax treaties in effect with only eight countries completely outside the OECD system. It is notable that 164 tax information treaties were signed during 2009 between the April and September meetings of the G20. While steps have been taken towards automation through the adoption of the EU Savings Directive, the widespread automatic exchange of information is still some way off.

New Regulations: FATCA

Most recently, the US Department of the Treasury and the Internal Revenue Service (IRS) issued the proposed regulations providing guidance for foreign financial institutions (FFIs), non-financial foreign entities (NFFEs) and US withholding agents to implement various provisions under the Foreign Account Tax Compliance Act (FATCA).

Simultaneously, the governments of the US, France, Germany, Italy, Spain and the UK released a joint statement explaining that they were exploring a common approach to FATCA implementation through domestic reporting and reciprocal automatic information exchange. The joint statement emphasised the willingness of the US to reciprocate by automatically collecting and exchanging information on accounts held in US financial institutions by residents of each of the respective countries. Following the release of the joint statement, representatives from Ireland, Luxembourg, the Netherlands, Poland and South Africa have all made statements supporting the adoption of this bilateral approach.

Enacted in 2010 as part of the Hiring Incentives to Restore Employment Act (HIREA), FATCA includes a series of provisions designed to combat offshore tax evasion through increased customer due diligence and information reporting. FATCA threatens to impose a 30% withholding tax on payments of most US source income and certain US source gross proceeds, unless an FFI enters into and complies with a FFI Agreement with the IRS. This agreement requires FFIs to identify US account holders and report the related account information directly to the IRS.

As a result, institutions will have to implement new processes and procedures, including how to decide what constitutes an electronically searchable file, what information proves that an entity is an FFI or has an active trade or business and what constitutes a diligent review of a customer master file. In cases where a foreign law prevents the reporting of any information with respect to a US account, the FFI will also need to obtain a valid and effective waiver of the law from each holder of the account or may have to exit the relationship.

For the intergovernmental approach to work, governments will have to pursue the necessary legislative changes to require FFIs in their jurisdiction to collect and report to the authorities of the FATCA partner country the required information, enable FFIs established in the FATCA partner country to apply the necessary diligence to identify US accounts and transfer to the US, on an automatic basis, the information reported by the FFIs. While it is expected that FFIs in FATCA partner countries will be relieved of certain obligations, such as to close accounts and apply withholding, there is also a commitment to develop practical and effective alternative approaches to achieve the policy objectives.

The required legislative changes and updates to tax information exchange agreements (TIEAs), in particular to support the automatic exchange of information, will take time, and the transfer of information will cost money. Exactly how long, and who pays, has yet to be decided but the FATCA withholding commences from 1 January 2014 in certain instances and the first reporting date is in September 2014. The alternative approaches are as yet unknown.

The joint statement also makes reference to the OECD and the EU. The OECD Treaty Relief and Compliance Enhancement (TRACE) and the EU Clearing and Settlement Fiscal Compliance Experts’ Group (FISCO) groups have worked on models for automatic exchange of information, including the development of reporting and due diligence standards. It appears that FATCA has moved the world closer to the automatic exchange of information and once again puts customer relationships firmly in the regulatory spotlight.

A New Era of Information Exchange

It is important to recognise that FATCA is the latest in a series of tax evasion enforcement activities. Historically, a number of tax authorities implemented taxpayer disclosure opportunities. Under a variety of programmes, taxpayers were offered reduced penalties and potential immunity from criminal prosecution. Jurisdictions that have adopted this approach to tackling non-compliance include France, Germany, Italy, the Netherlands, the UK and the US. The purpose of these programmes is to recover revenues which are potentially outside the jurisdiction of the tax authority, to allow taxpayers to bring their affairs into order and also to collect information in respect of on-compliant financial institutions which may provide the basis for further investigations. Her Majesty’s Revenue and Customs (HMRC) in the UK estimated that 20 out of every 100 names provided by the banks in accordance with the UK bulk disclosure opportunities would yield tax over and above amounts previously disclosed. A number of tax authorities have also paid for information about their citizens. It was reported that Germany paid US$7m for a list of German citizens with assets in Liechtenstein and agreed to buy a list of alleged tax evaders with assets in Switzerland.

In 2001, the IRS introduced the Qualified Intermediary (QI) regime primarily to address concerns that there was a significant loss of tax as a result of the incorrect operation of tax exemptions and treaty benefits, as well as to tackle tax evasion by US persons. QI was designed to combat the use of the so called ‘address’ rule whereby treaty benefits were given based on the address of a financial institution as opposed to the residence of the beneficial owner, to encourage foreign investment into the US and to give more insight into the assets held offshore by US persons.

QI requires a financial institution, or anyone else the IRS agrees to, to enter into a 60-page agreement with the IRS which typically lasts for six years, the agreement covers branches but not subsidiaries, details documentation, withholding and report obligations and includes the requirement for an external audit. A financial institution retains the choice about whether or not to designate an account held at an upstream paying agent as being covered by the agreement which also provides that the confidentiality of non-US direct customers may be preserved, and that treaty relief is given at source rather than on a reclaim basis.

QI agreements are also characterised by the requirement for a generic country specific Know Your Customer (KYC) attachment to be negotiated with the IRS. The KYC attachment is typically negotiated by the banking association of the country in which the QI is situated and more than 70 countries have agreed KYC attachments, including Cayman Islands, Hong Kong, Liechtenstein and United Arab Emirates (UAE).

In January 2009, the OECD Committee on Fiscal Affairs approved a pilot group to develop an implementation package for improving the procedures for claiming tax relief at source for all cross-border investors. The pilot group was requested to maintain on-going communication with a parallel European Commission (EC) group. The proposed OECD system requires countries to develop systems for portfolio investors to claim treaty benefit and for authorised intermediaries to make claims on behalf of customers on a ‘pooled’ basis. Beneficial owner information would be the responsibility of the authorised intermediary and intermediaries would provide the income source countries with the name and address of the beneficial owner and, where applicable, the investor’s taxpayer identification numbers or equivalent. The information received by the source countries would then be provided to the government of the investor’s residence country and the residence country would inform the source country if the investor is not in fact resident. The system also requires an independent review of the intermediaries’ compliance.

On 13 November 2008 the EC adopted an amending proposal to the Savings Taxation Directive (EUSD), intending to close perceived loopholes to prevent tax evasion. The EC proposal seeks to improve the Directive, to ensure the taxation of interest payments which are channelled through intermediate tax-exempted structures and to extend the scope of the Directive to income equivalent to interest obtained through investments in some innovative financial products, as well as in certain life insurance products. The changes primarily affect product selling and distribution, product design and the audit and filing processes. If the scope of the Directive is extended to include more products it will affect the competitiveness of those products and products designed to fall outside the scope of the Directive, such as offshore life insurance ‘wrappers’, will need to be reviewed. The changes to the compliance processes will result in more evidence being required to support EUSD filings, which in turn will drive procedural and systems changes for administrators and product providers.


What is clear is that financial institutions find themselves sitting at the heart of various information reporting and withholding regimes. As providers of services and products, financial institutions act as intermediaries and are able to provide an invaluable source of information with regard to the tax status of their customers and the associated flows of funds. By requiring financial institutions to withhold tax and report taxpayer information, the tax authorities create a cost effective control mechanism.

Many institutions were waiting for the proposed FATCA regulations before starting to deal with the required operational and compliance changes in any detail. With the issuance of the proposed regulations and the joint statement it is clear that FATCA is not going away and that governments and other international organisations are moving towards a more cooperative approach to combating international tax evasion.

With an effective date next year, institutions now need to base the design and implementation of updated processes, procedures and systems on the proposed FATCA model. However, the FATCA model remains incomplete and these changes may well have to satisfy the demands of stakeholders from governments and organisations around the world. To try to ensure that any effort and expenditure incurred now works in as many circumstances as possible, it makes sense to focus more on what the institution appears to need to know about its customers, as opposed to meeting the uncertain demands of a specific regime.

FATCA has pushed tax to the forefront of the regulatory change agenda and under that agenda the spotlight remains firmly on the customer.

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