Taxing times for United States citizens

In June, Cayman law firm Solomon Harris organised a webinar highlighting tax considerations for US and UK residents planning to relocate to the Cayman Islands and those who are already living here. In this first of a two-part series Business Journalist Michael Klein reports on the session US tax compliance for Cayman companies and residents.

Recent events have radically changed the tax compliance landscape for US citizens who have income that comes from outside the United States, according to Asher Harris of Asher Harris Law Office in New York, who started his online presentation with a general breakdown of US tax basics.
 
According to US tax law any US citizens, US residents and temporary US residents are subject to US income tax on their worldwide income.
 
Harris explained that while US income is largely assessed on the basis of self-reporting in combination with the cross-checking of corresponding documentation, non-US income was until now assessed on a self-reported basis only. For some time US citizens, residents and temporary residents have been required to file a report called a Foreign Bank Account Report or FBAR with the Internal Revenue Service. In addition, any non-US income had to be declared in a tax return.
 
“If you had money in the Cayman Islands, if you earned money outside the United States, it was really your own decision as to whether or not that would be reported,” said Harris.
 
“The income had to be reported on a tax return, the asset had to be reported on an FBAR, but it was really up to you.”
 
As the self-reported information of Foreign Bank Account Reports could not be verified or cross-checked the level of tax compliance on income earned outside the US was comparatively low.
 
However, said Harris, this is about to change.
 
FBAR
The recently passed HIRE Act strongly increases the emphasis on FBAR compliance. The Foreign Bank Account Report is required for any foreign account owned by a US person that exceeded $10,000 at any time during the previous year. As such it must be filed by any US person with a financial interest in or signature authority over a foreign bank account.
 
Accounts subject to the FBAR rules include not only bank accounts but also accounts with securities dealers, investment funds, private partnerships and cash value life insurance policies.
 
“What has happened is that the trend has shifted,” said Harris. “The burden of tax compliance has now been placed on third parties as well as the person who owns the money.”
 
Anyone who has signature authority but no ownership of a foreign account has the responsibility to report those assets to the IRS. This signature authority includes authority that can only be exercised together with another person, clarified Harris.
 
So, for example if there is a bank account in the Cayman Islands and in order to transfer money out of that account two signatures are required from both a US person and a Caymanian, the US person would have to file an FBAR, provided the threshold of $10,000 is exceeded.
 
Even if the US person has signature authority over non-US persons and non-US investors in the account, under current law the US person has to file the FBAR regardless of who the owner is.
 
Although there are exceptions for officers of publicly traded companies and banks, these are fairly technical and have to be carefully evaluated to see whether an exception applies, stated Harris.
 
The point is that many persons with administrative authority over non-US assets may be subject to the FBAR filing requirement, he said.

FACTA
A similar shift in the reporting requirement to third parties will occur as a result of the Foreign Account Tax Compliance Act that was enacted into law as part of the HIRE Act in March 2010.
 
“Financial institutions are now essentially going to be required to disclose under FACTA the income earned by US persons.”
 
In order to escape a withholding tax of 30 per cent on their US source income, introduced by the new law, foreign financial institutions have to enter into an agreement to either identify US account holders to the IRS or, if the account holder refuses to disclose the required information, to close the account. The disclosure agreement forces the reporting to the IRS of the name, account number and tax ID of any US person that is an account holder with the foreign financial institution.
 
Most of the rules governing the law are still underdeveloped and will take effect for payments made after the end of 2012, but it is important to focus on the rules sooner rather than later, argued Harris.
 
What makes the law particularly effective or threatening is that the withholding is applied to the payments of investment income, such as interest and dividends, and to the gross proceeds of the sale of US property that generates interest or dividends.
 
But the purpose of the law is not to generate tax revenue. “The intention is to force disclosure of assets held by US persons outside the US,” said Harris, and to pressure financial institutions to close the accounts of non-compliant account holders.
 
From a US perspective this is the beginning of a new international approach to tax information reporting, stated Harris. The expectation is that other countries will adopt similar approaches to tax information reporting for the foreign held assets and income of their citizens.
 
There are a lot of question marks over how the system will work, in particular how the disclosure agreements will be implemented and monitored. It is also not clear how a financial institution could disprove that an account holder is not a US citizen.
 
“I think one of the big questions will be what the practical implications are going to be,” said Harris.
 
What happens if investment income becomes subject to withholding? Can the institution legally close the account of a non-compliant US person? Can the institution legally withhold from the account of a non-compliant US person?
 
Or in the case of a fund, if investment income of a partnership is subject to withholding, can this tax be passed on to the US investors alone without sharing it with the other investors?
 
This will depend on the documents such as the memorandum and articles that were involved in the setting up of the fund, some of which may have to be amended, he said.
There is speculation that some funds will be compliant, with disclosure agreements for all US investors and others that may be non-compliant, who will structure their investments in such a way that they will not have US source income that may be subject to withholding tax.
 
“Financial institutions should ask themselves whether they want to be compliant, how much it will cost and how the cost burden will be shared between US and non-US investors,” advised Harris.
 
Another issue will be that Cayman’s Confidential Relationships (Preservation) Law is going to prohibit any financial institution from disclosing information without the consent of their clients. Harris drew a parallel to Swiss bank secrecy laws that came into conflict with US laws and stated that there may well be similar conflicts with respect to US and Cayman law.
 
“I think it is going to become increasingly important for fund managers, fund organisers and fund administrators to give thought to just how these rules will play out and […for financial institutions to decide] what strategies to adopt in order to prepare account holders, depositors and investors for the future.”

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