The Problem of Offshore Tax Abuse: The UBS Story
A 2012 study by James Henry, former Chief Economist at the McKinsey group, estimated that the amount of private financial wealth held offshore is, at minimum, between $21 trillion to $33 trillion, or 18 to 25 percent of all financial assets. Offshore tax evasion was the subject in the case of United States v. UBS AG. UBS is Switzerland’s largest bank and one of the world’s largest financial institutions. In 2007, Bradley Birkenfeld, a UBS banker and U.S. citizen, testified to the U.S. Senate Committee on Homeland Security and Governmental Affairs that UBS was helping its U.S. customers evade taxes. In 2009, UBS entered into a deferred prosecution agreement with the U.S., agreed to pay a $780 million fine, and admitted to helping U.S. taxpayers hide accounts from the IRS.
In the aftermath of the UBS case, Congress passed the Foreign Account Tax Compliance Act (FATCA). The United States Senate revealed that offshore tax evasion accounts for a revenue loss of approximately $100 billion per year, and Congress’ stated purpose in passing FATCA was to combat such evasion.
Tax Enforcement Mechanisms in the U.S.
Third-party withholding and reporting are two important tax enforcement mechanisms currently employed by the federal government. Third-party withholding, the process by which an employer deducts a portion of an employee’s income and transfers tax payments to the IRS, is one way to ensure tax liabilities are met. This is the reason that income tax is withheld from the pay of most U.S. employees. In addition, third-party reporting, a government requirement for a financial institution or other agent to record income earned and to provide the IRS with the information, allows the IRS to verify the accuracy of tax returns filed by individual taxpayers. The efficacy of such a mechanism is validated by the fact that there is little underreporting of wage income due to the W-2 reporting requirements.
International taxation, however, frustrates enforcement efforts. By holding funds in foreign financial institutions, U.S. taxpayers avoid the reach of the IRS. The IRS’s access to taxpayers’ information is especially difficult in tax haven countries like Switzerland, as was the case in the UBS matter. The United States Government Accountability Office uses four characteristics to define tax havens: (1) no or nominal taxes; (2) lack of effective exchange of tax information with foreign tax authorities; (3) lack of transparency in the operation of legislative, legal or administrative provisions; and (4) no requirement for a substantive local presence.
For such designated countries, to get access to taxpayers’ information, the IRS relies on international tax information exchange agreements (TIEAs). Most TIEAs provide that foreign entities are only required to respond to specific requests for information. In order to receive information about an individual taxpayer, the IRS must know the taxpayer, know their financial institution, and have a credible suspicion of tax evasion. This is a less effective enforcement mechanism than third-party withholding and information reporting. As such, FATCA was designed to combat offshore tax evasion through enhanced reporting and sanctions. Understanding the methodology by which FATCA achieves this aim is essential component of understanding the crusade against offshore tax abuse.
FATCA Foreign Asset Reporting: Self-reporting
FATCA requires individual U.S. taxpayers holding “specified foreign financial assets” in excess of $50,000 during a taxable year to report these assets to the IRS. “Specified foreign financial assets” include: (1) any financial account maintained by a foreign financial institution; (2) any stock or security issued by a foreign person; (3) any financial instrument or contract held for investment where the issuer or counterparty is a foreign person; and (4) any interest in a foreign entity. There is a penalty for up to $50,000 for a failure to report these assets. (26 U.S.C. § 6038D).
FATCA Foreign Asset Reporting: Third-party reporting
FATCA also requires “foreign financial institutions” (FFIs) with U.S. customers, and “nonfinancial foreign entities” (NFFIs) with substantial U.S. owners, to report information about U.S. taxpayers to the IRS. The term FFI is defined in the statute to mean “any financial institution which is a foreign entity.” “Foreign entity” does not include a financial institution, which is organized under the laws of any possession of the United States. “Financial institution” means “any entity that (a) accepts deposits in the ordinary course of a banking or similar business; (b) holds financial assets for the account of others as a substantial portion of its business; or (c) is engaged…primarily in the business of investing, reinvesting, or trading in securities,…partnership interests, commodities,…or any interest…in such securities, partnership interests, or commodities.” The FFI definition makes it difficult to imagine a financial institution that would not fall under of the statute. FATCA’s NFFI definition is even more expansive and includes “any foreign entity which is not a financial institution,” although the burden on NFFIs is relatively lighter than on FFIs. FATCA does not apply to foreign governments, foreign central banks, intergovernmental organizations, and most nonfinancial publically traded corporations. (26 U.S.C. §§ 1471, 1472).
To meet the information reporting requirements, an FFI must enter into an agreement with the IRS; the FFI must agree: (1) to obtain information from each holder of its accounts necessary to determine which, if any, of such accounts are U.S. accounts; (2) to report name, address, and TIN of any such account holder annually to the IRS; (3) to withhold 30 percent tax on payments to account holders who fail to supply information as to U.S. status; (4) to comply with any IRS requests for more information about U.S. accounts; (5) to seek a waiver from a U.S. account holder if foreign law prevents disclosure, and to close the account if a waiver cannot be obtained; and (6) to withhold 30 percent tax on certain pass-through payments to other non-participating FFIs. A simple example of a pass-through withholding requirement is illustrative: if Deutsche Bank enters into an FFI agreement with the IRS and transfers $1 million to a noncompliant Swiss bank, it may be required to withhold and transfer to the IRS 30 percent of that sum. The Swiss recipient could then challenge that withholding by filing an American tax return. Why would any foreign financial institution agree to take on the reporting function for the IRS, a foreign tax authority?
If an FFI does not enter into a voluntary agreement with the IRS, it will be subject to a 30-percent withholding tax on its U.S.-source interest and dividends as well as proceeds from the disposition of property that gives rise to U.S.-source interest and dividends. Again, an example to better demonstrate this process is helpful. If Deutsche Bank, which is not in an FFI agreement with the IRS, invests $80 of its German customer’s money in Facebook stock, that investment increases in value to $100, and the client then requests the bank to sell the Facebook stock, the sales proceeds will be subject to a 30 percent withholding tax. Having invested $80 in U.S. stock, the client will only receive $70 from the sale. Foreign financial institutions that want access to American capital markets will be forced to report their U.S. clients to the IRS.
Although curbing offshore tax evasion by Americans is a fair goal, other governments, the private sector both in the U.S. and abroad, and Americans living overseas are not in a hurry to praise FATCA. Americans living abroad argue that in addition to the burden of double taxation – the U.S. is the only nation in the world that taxes citizens who live overseas – they must deal with complex reporting requirements that often require expensive services of a professional tax advisor. Under existing law, these individuals must already report their foreign accounts to the U.S. Treasury. Under FATCA, they must now report their funds to the IRS as well. In addition, FATCA will make it harder for Americans living abroad to obtain a mortgage or purchase foreign insurance policies since many FFIs refuse to deal with Americans as a result of FATCA. Many agree that the U.S. should exempt bona fide residents abroad from the reporting requirement of FATCA, or better yet, adopt residence-based taxation instead of citizenship-base taxation. That would eliminate issues of double taxation and double filing.
Another issue with FATCA is the conflict with banking and data privacy laws in other countries. For example, in Switzerland, Swiss financial institutions typically may not disclose client information to third parties, and criminal penalties can be imposed if they do. Tax evasion is not illegal in Switzerland, only tax fraud is. Even not tax haven countries like Japan are raising similar privacy concerns. Japanese bankers stated that Japanese institutions may be forced to withdraw their investment from the U.S. Critics point out that international cooperation is thus essential to facilitate FATCA implementation. Indeed, France, Germany, Italy, Spain, and the United Kingdom agreed to work with the United States to fight tax evasion. But now American banks are unhappy about the U.S. government pledge to foreign governments to require American financial institutions to report to other countries about foreign investors holding accounts in the U.S. In addition, tax havens like China, Panama and Russia have yet to commit themselves to similar efforts. The identities of tax evaders with accounts in these countries will remain unknown to the IRS.
Finally, the law imposes a huge burden on FFIs. According to the Institute of International Bankers, world banks would have to spend at the minimum $250 million to comply with FATCA. According to the Congressional Budget Office, FATCA is expected to raise revenues of approximately $800 million per year for the U.S. There are also additional costs to the IRS to process the data produced. The concern is that the revenue raised is likely to be outweighed by the cost of implementing FATCA.
Critics have expressed doubts that FATCA will work. FATCA will take effect on June 30, 2014. The law was signed in 2010 and was initially scheduled to go into effect January 2012. Indeed, for the past two years the Treasury Department has struggled to implement the new rules. Most agree that cooperation with foreign governments is crucial to facilitate FATCA implementation. As the first significant step toward a more transparent global economy, FATCA is a starting point with a long way to the finish line. But it promises to be an interesting run.