Beware: US FATCA looming over non-participating financial institutions in foreign countries
Monday, 3 March 2014 00:58
FATCA to catch tax dodgers
Dodging of taxes by taxpayers is the biggest headache for tax administrators throughout the world. This is more so for the US tax administrator, Internal Revenue Service or IRS. In that country, the annual average tax loss by Federal Government alone due to tax evasion has been about $ 300 billion or 2 % of its GDP.
Based on this, over the 10-year period from 2001 to 2010, it has been estimated that the government has lost about $ 3 trillion which is a substantial sum. To put a stop to tax evasion by US citizens, Obama Administration enacted in March 2010 a special law titled Foreign Account Tax Compliance Act or FATCA.
After three abortive attempts at implementing it on 1 January 2013, 1 July 2013 and 1 January 2014, the final date of implementation of FATCA has now been fixed for 1 July 2014.
US IRS Chief: No more extension of FATCA
On the previous three occasions, the implementation dates were postponed to give sufficient breathing space for foreign financial institutions to get ready to comply with FATCA. Hence, there is a wide expectation that the currently fixed date of implementation too will get postponed for another period.
Claiming compliance difficulties, five US major associations in the banking and insurance industry have already requested for a further extension of its implementation date. However, IRS Commissioner John Koskinen affirmed last week in a telephone conference with reporters that no further extensions would be given and FATCA would come into force on 1 July 2014.
FATCAâ€™s threat should be properly evaluated
If FATCA comes into force in four monthsâ€™ time as scheduled or on a later date if that date is extended, it has major implications for Sri Lanka and other non-participating countries. It is the view of this writer that Sri Lanka should correctly appraise the threat looming over it and take appropriate measures to defuse it before it becomes too late.
USA: Cooperate with us or be ready for punishment
US income tax laws require US citizens to pay income tax whether they are resident in USA or not or whether they earn income within USA or not. Citizens for tax purposes include both full citizens and permanent residence certificate holders. To evade taxes, many US citizens have chosen to invest money outside the country and not to report the same in annual tax returns despite it being a legal requirement under the law.
Most of the moneys have been invested in countries where there are lax or no tax laws, stringent secrecy clauses or high interest rates. This last reason has become important in the present period mainly because of the near zero US interest rates due to its liberal money printing policy known as quantitative easing. Thus, high interest rates in developing countries like Sri Lanka have attracted much of the US savings in the recent past. In addition, many migrants to USA have chosen to remit a part of their incomes regularly to non-resident foreign currency accounts back at home to earn high interest rates.
Since wide-spread tax evasion has become a critical issue, it is quite natural for the US authorities to tighten the noose on tax evaders. The enactment of FATCA in 2010 was therefore the natural outcome of this initiative. It seeks to fill in the gap in information by requiring foreign financial institutions or FFIs to cooperate with US authorities on three counts: Reporting on investments made and incomes received by US citizens regularly to IRS, performing due diligence on US citizens opening new accounts and withholding 30% of payments originating from USA to non-participating FFIs.
Many countries of importance have chosen to cooperate with USA
So far, 20 countries, including the rest of the G5 countries â€“ UK, France, Germany and Japan â€“ have agreed to cooperate with USA in the implementation of FATCA. The list includes several of the worldâ€™s tax havens, namely, Bermuda, Isle of Man, Cayman Island, Malta and Switzerland. China has declared that its financial institutions are not authorised to release information to outsiders. Hence, if China is to cooperate with USA on this matter, it has to enter into a special Inter-Governmental Agreement or IGA with USA. But so far China has not indicated its intention of doing so.
Among the countries in the developed world which have signed IGAs include Australia, Canada, Denmark, Ireland, Italy, Netherland, Norway and Spain. From the middle income world, other than the tax havens, only Mauritius, Hungary and Mexico have signed the agreements. So far no developing nation has agreed to cooperate with USA on this matter. Hence, Sri Lanka is not a loner among the worldâ€™s nations since there are many who have not gone for a cooperative agreement with USA.
Report all investments over $ 50,000
The cooperation which a country would extend to USA on FATCA will be formalised in two ways, at the financial institution level and at the governmental level. At the financial institution level, FFIs can register with IRS to perform the three functions under FATCA as outlined above. Financial institutions for this purpose have been broadly defined to include banks, non-bank entities, insurance companies, investment, pension and mutual funds and supermarket chains which have issued credit cards to their customers. They should report regularly to IRS on the investments exceeding $ 50,000 made by US citizens.
"In the event of Sri Lanka not entering a cooperative agreement with USA, it will be treated as a recalcitrant nation. That is too costly for the country. Sri Lankaâ€™s fragile foreign reserve balance which is mainly made up of moneys invested by US based funds in government paper is at a particular risk. Its choice is therefore one of â€˜devilâ€™s alternativesâ€™ if one borrows a term from the British writer Frederick Forsyth who wrote a novel under the same title. When a country is faced with a devilâ€™s alternative, whatever it does will bring it equivalent costs. It is therefore necessary for Sri Lanka to make an assessment of the threat and take mitigating measures before it becomes too late"
At governmental level, an Inter-Governmental Agreement or IGA will be signed with USA facilitating FFIs to supply the required services when there are secrecy laws prohibiting them from reporting on their customers. After an IGA has been signed, the government could enact enabling legislation to give effect to its provisions. Since under Sri Lankan laws, financial institutions are prohibited from disclosing information on customers to outside parties, it is necessary for Sri Lanka to go for the second option if it chooses to cooperate with US authorities on FATCA.
Cooperating FFIs are marked by GIIN
FFIs which have been either registered with IRS direct or are authorised by IGAs to supply information to IRS are called participating foreign financial institutions or PFFIs. These institutions are issued with a Global Intermediary Identification Number or GIIN so that they could be easily identified as FFIs cooperating with IRS. All other financial institutions are therefore non-participating foreign financial institutions or NFFIs that do not have a GIIN.
Since NFFIs are subject to punitive action in the form of withholding 30% of withholdable payments under FATCA by US authorities, the validation of a transaction by a GIIN is necessary to avoid such penalties being imposed on them. This withholding is expected to induce NFFIs to join the PFFI Club and cooperate with US authorities in cracking down tax evasions. This is because retention of dues at 30% as FATCA has provided for is both prohibitive and killing for any FFI.
All current or capital receipts are withdrawable payments
The withholding clause will come into effect on 1 July 2014. This clause will apply to two types of payments: Withholdable payments and Passthru payments. A withholdable payment will arise in two ways. One is all US source incomes that are â€˜fixed or determinable and annual or periodicalâ€™ abbreviated as FDAP payments.
The other is the gross proceeds from the sale or other disposition including redemption of property that can produce US source interest or dividend income. Accordingly, all interest or dividend receipts on investments made in USA or passive incomes such as rents and royalties or any sale proceeds of shares, bonds or debentures or even withdrawal of deposits constitute withholdable payments. PFFIs have agreed to withhold 30% of such payments made to NFFIs. Under Passthru, even the payments which are made outside USA are called withholdable payments and subject to the same 30% retention.
Withdrawable clause to affect all investors
This is the clause that would very badly affect banks, financial institutions, hedge funds, mutual funds, and other types of funds operating in the share market in Sri Lanka when they deal with US citizens, in the event Sri Lanka does not become a cooperating country. Sri Lankaâ€™s exports to USA are not subject to this withholdable clause.
However, if the export proceeds are kept in temporary US bank accounts or invested temporarily in US investments, when such deposits are withdrawn or interest on the same is paid, they become withholdable payments and are subject to the retention of 30% of the payment.
Grandfathering of existing investments
The withholding clause has imposed significant burdens on foreign investors and US companies that do business with them. As mentioned earlier, the compliance with FATCA after 1 July 2014 will require companies to do serious up-front diligence on investors to avoid withholding and such diligence cannot be exercised in the case of investments already in existence.
It is like the Know-Your-Customer or KYC rule imposed on banks by their regulators. It is not difficult for a bank to complete the KYC process in the case of a new customer after the rule has become effective. That is because all the necessary information to identify the customer could be obtained from him at the time of opening the account. But it may not be so easy in the case of customers who already have accounts unless they have volunteered to supply the relevant information to the bank. In such cases, a period is given by regulators to accomplish this requirement for the customers who already have accounts as at the date on which the new rule had come into effect.
In financial terminology, this is known as â€˜grandfatheringâ€™, a term borrowed from the US Constitutional provisions where a new rule is applicable to new citizens but grandfathers are permitted to be treated under the old rules. A similar grandfathered provision has been made in FATCA too.
Non-cooperating FFIs to suffer heavily
Under the grandfathered obligation rule, US companies do not have to make withholding on obligations that are already in existence as at 1 January 2014. However, that concession ends on 30 June 2014, one day before the withholding requirement becomes effective. As such, all investments made by foreigners in USA are subject to the withholding requirement after 1 July 2014 if a country has not agreed to cooperate with US authorities by signing an IGA.
Sri Lanka has so far not signed an IGA and nor is it reported to be completing the process needed for signing one. Hence, all Sri Lankan investments in US Treasury certificates, corporate bonds and debentures, shares, temporary money market accounts, mutual and pension funds, trusts etc are subject to the withholding clause after 1 July 2014.
The affected investors are the countryâ€™s Central Bank itself, commercial banks, insurance companies, non-bank financial institutions, large companies which have made such investments in USA and private citizens who are keeping interest bearing US accounts. Since the withholding is at 30% of the benefits, it is a significant cost to such investors.
Republicans pledge to repeal FATCA
Many have criticised that USA in its eagerness to crack down tax evasions has introduced a self-destructive time bomb. It has forced the non-cooperating countries to cooperate with US authorities at the pain of avoiding the retention of a substantial amount of profits they are earning by investing in USA. The criticism is that USA has ignored the reaction of these countries to the pain to be inflicted on them.
One prominent country is China. If it does not agree to cooperate with USA on FATCA, its colossal investments in USA amounting to some $ 3 trillion will be subject to retention of 30% of both income and the transfer of the sale proceeds outside in the event of liquidating such investments. China being the biggest loser under FATCA is likely to react in the most unfriendly manner. It may even seek to muster support from among likely losers for promoting markets outside USA.
On a previous occasion when USA prohibited its banks from engaging in investment banking activities under the now repealed Glass-Steagall Act, a vibrant investment banking sector was developed outside USA. Hence, it is widely believed that FATCA will rid USA of its status as the worldâ€™s leading financial centre. In view of these risks faced by USA, the Republican Party is reported to have resolved to request the Congress to repeal FATCA. Despite these risks, threats and costs, the US authorities are reported to be going ahead with their previous plan of implementing FATCA as scheduled.
Sri Lanka should properly appraise the cost of FATCA
In the event of Sri Lanka not entering a cooperative agreement with USA, it will be treated as a recalcitrant nation. That is too costly for the country. Sri Lankaâ€™s fragile foreign reserve balance which is mainly made up of moneys invested by US based funds in government paper is at a particular risk. Its choice is therefore one of â€˜devilâ€™s alternativesâ€™ if one borrows a term from the British writer Frederick Forsyth who wrote a novel under the same title. When a country is faced with a devilâ€™s alternative, whatever it does will bring it equivalent costs. It is therefore necessary for Sri Lanka to make an assessment of the threat and take mitigating measures before it becomes too late.
(W.A. Wijewardena, a former Deputy Governor of the Central Bank, could be reached at email@example.com.)