Financial institutions face US tax reporting pressure

The Cayman Islands Government and Cayman Finance organised a tax seminar in April for financial institutions as well as US passport and green card holders in Cayman about new US tax legislation that will force foreign financial institutions to disclose information regarding US taxpayers directly to the Internal Revenue Service.

At the event Dan Scott, regional partner with Ernst & Young, described Foreign Account Tax Compliance Act as one of the most important and far reaching tax laws to come out of the US, adding that the new law will impact every financial institution in the Cayman Islands. It will also affect every Caymanian tied to the US through residency or citizenship, he noted.

The idea of FATCA is to force foreign banks and investment funds to collect customer data from US persons, as if they were US financial institutions. In contrast to US institutions, however, the foreign financial institutions will then also have to annually report to the IRS account information on all US account holders.

The fact that the US has no authority over foreign financial institutions that are not operating in the United States seems to be of little concern to the US government, after it was able to successfully pressure Swiss banks into handing over account information on their US customers.

FATCA uses a 30 per cent withholding tax on all payments between the US and non-compliant US persons and foreign financial institutions as leverage to obtain the information that can then be used for tax enforcement purposes.

Foreign financial institutions, including those in Cayman, are left with a problem. Banks, trusts, brokerages, custodians, investment funds and other financial institutions will have to find ways to comply with FATCA.

They have to determine who their US customers are, including those with dual nationality, and develop and implement new systems that are capable of identifying US persons and collecting the data that has to be relayed to the IRS on an annual basis.

All financial institutions will need to analyse their systems to determine how to generate and report the required information, communicate with their clients, customers or investors on what is expected from them, decide how to deal with those that are not supplying the needed information and, in a hedge fund for example, how to segregate non-compliant from compliant investors.

The financial services industry in Cayman, and elsewhere in the world, naturally objected to the law, which puts a significant financial burden on financial institutions and instrumentalises them to effectively become the tax enforcement arm of the US executive.

Cost to foreign financial institutions

Due to the high development, implementation and maintenance costs of FATCA, some smaller banks in Switzerland have already decided to close the accounts of US customers.

But, according to Gonzalo Jalles, the head of the Cayman Islands Bankers’ Association and CEO of HSBC in Cayman, this will not be an option for commercial banks in the Cayman Islands as well as any other international banks, especially those with operations in the US. In today’s financial markets everything is simply too closely connected to avoid US dollar clearing or any business ties with the US.

Once a foreign financial institution is deemed non-compliant, other banks may also be forced by FATCA to apply 30 per cent withholding on transactions with those institutions.

Brett Hill, president and CEO at Fidelity Bank (Cayman) Limited, noted that the necessary administrative systems for FATCA would be “hugely expensive” and onerous on banks.

“We will basically all be working for the US [tax authorities],” he said. “It’s almost as if the onus is on the banks to prove a customer is not a US person.”

Hill also made clear how far reaching and expensive the FATCA undertaking is going to be, in exchange for very little additional tax revenue in return. 
He estimates there are approximately 250,000 foreign financial institutions that have to implement FATCA, but only $10 billion in additional tax revenue is expected by the US government, or roughly $40,000 per bank, substantially less than what it is going to cost smaller institutions to implement and maintain the information systems needed.

For larger organisations the costs will be significant on a global level but manageable on the local level, said Jalles.

Stuart Dack, president and CEO of Cayman National Corporation, believes that because Cayman has experience with similar requirements in the past, for example with regard to know-your-customer information, the EU Savings Tax Directive and more recently the Dormant Accounts Law, FATCA will be easier to deal with for Cayman banks than for other foreign financial institutions.

FATCA will indeed be costly he concedes, but although it is difficult to quantify at this stage how expensive it is going to be, he does not expect it to “cost millions of dollars”.

He also believes that the requirements of the law will change before it becomes effective and make the final provisions of FATCA more workable.

“I think over the next few months there will be some shifting and we’ll end up with something that is sensible,” he said, referring to representations that were made on behalf of the financial services industry in the Cayman Islands.

Lobbying efforts

US law firm Sidley Austin, which advises the Cayman government and acts on its behalf in the United States and the European Union, collected comments from the financial services industry through Cayman Finance and presented those views in a letter in November 2010 to the IRS and US Treasury.

This was followed by a meeting between the US executive bodies and a Cayman Islands government delegation in Washington, DC, in March.

The comments submitted sought additional exemptions from withholding with respect to Cayman investment funds that do not permit the participation of US persons, such as foreign feeder funds or other hedge fund structures and also with respect to other widely held Cayman investment funds, said Thomas Yancey an attorney with Sidley Austin at the tax seminar.

The delegation also asked for exemption for payments to structured finance issuers organised under Cayman law and a broadening of the retirement plan exemption for Cayman registered retirement plans.

The letter further outlined why existing KYC/AML standards should be sufficient to obtain the necessary customer information without having to obtain US income tax forms from account holders, Yancey said.

He believes that while not everything that was proposed has been accepted, the latest FATCA guidance notice, released in April 2011, shows indications that the comments did have an effect.

“There is for instance still a mention that the requirement to obtain US income tax forms may be replaced by the ability to obtain other documentation.”

And an exemption for foreign feeder funds under certain conditions are also still under consideration by the IRS and the US Treasury, Yancey said.

In this context the history of cooperation between the Cayman Islands and the US in tax matters and anti-money laundering could become very important.

Sidley Austin attorney Joseph Tompkins, who frequently represented the Cayman Islands in the past, described the relationship between Cayman and the US over the years through the Mutual Legal Assistance Treaty and the US tax information exchange agreement. In both cases Cayman was the first offshore jurisdiction to sign such a treaty with the US.

“So we have tried to cultivate that kind of relationship with the government in the United States and that has paid a lot of dividends and sometimes you see them and sometimes you don’t,” Tompkins stated.

Tompkins confirmed a number of issues raised in Cayman with regard to FATCA “that we may have some influence on” are still “in play”. Additionally the government wants to submit additional comments in response to the latest FATCA guidance from April 2011 in the near future.

Cayman should continue to educate lawmakers in the US about the Cayman Islands, Tompkins advised, citing the report by the US Government Accountability Office on the Cayman Islands as a positive example.

What do foreign financial institutions have to do to identify US account holders?

In Cayman, US passport and green card holders will first and foremost be concerned with the way their account information is treated by banks and other financial institutions.

In its latest guidance, the IRS outlined five steps for financial institutions to identify whether an account held by an individual is a US account, a non-US account or a recalcitrant account that will be subject to withholding tax.

The procedure is not only complex because it differs depending on type of account.

In a first step all accounts held by known US citizens will be designated as US accounts, if the balance exceeds $50,000. For depository accounts held by natural persons there is an exemption from the reporting if the account balance is less than $50,000.

There are however two caveats, Yancey explained. Firstly, all accounts that have a level of common ownership within a financial institution and its affiliates will be treated as a single account. This means for joint account holders that the full balance of the accounts will be attributed to each account holder. Secondly, the financial institution may decide to report these known US accounts anyway, even if the balance does not exceed $50,000.

Gonzalo Jalles the chairman of the Cayman Islands Bankers Association for instance believes that banks will opt to err on the side of caution by reporting too much rather than too little, given the significant implications of non-compliance.

In a second step banks and other financial institutions will have to turn to the accounts that have not been specifically identified as US accounts and again accounts with a balance of less than $50,000 can be designated as non-US accounts, if the bank elects to do so.

In a third step all private banking accounts not covered by the first two steps will be subject to a review of all electronic and paper records to identify the status of each private banking client, including family members associated with the account relationship.

The bank will require from a customer either a completed IRS form W-9 certifying US status or IRS form W-8 BEN certifying foreign status, together with the foreign passport or other government issued documentation confirming the foreign status.

The same procedure applies for remaining accounts for which the bank has US indicia in its records, such as a US place of birth for an account holder, a US residence or correspondence address or a standing instruction to transfer funds to the US and others.

For customers born in the US, but with foreign status, financial institutions will also have to request a written explanation regarding the renunciation of US citizenship or other reasons that explain why the person did not become a US citizen at birth to be able to treat the account as a non-US account.

In a fifth step financial institutions must then “diligently review” all files associated with accounts with a balance of more than $500,000 that were not covered by the first four steps.

There is no requirement to go beyond the due diligence in these steps and for instance ask an account holder whether they are a US person.

There is a “hint of don’t ask, don’t tell” embedded in these rules, said Yancey. “If you don’t see US indicia, then under these procedures your only duty is to not accept any information that you have, which you know to be incorrect.” This is also highlighted in a statement made in a report by Manal Corin, the international tax counsel for Treasury, who said: “Currently we are not requiring FFIs to specifically ask their account holders if they are US citizens”, Yancey added.

What will foreign financial institutions report?

Banks will have to submit name, address and US taxpayer ID of US persons that are account holders or US owners of account holders that are a US –owned foreign entity, as well as the account number and the year-end account balance or value converted into US dollars.

In the case of deposit and custodial accounts financial institutions need to report the gross amount of dividends, interest and other income paid or credited to the account as well as the gross proceeds from the sale or redemption of property paid or credited to the account.

For equity or debt interests in a reporting foreign financial institution all distributions, interest and redemption payments have to be reported.

If an account is closed the gross amount withdrawn upon closure of the account also has to be reported.

In addition the IRS may request any other information it deems appropriate, including copies of account statements which must be retained for 5 years.

EU protest and alternative proposal

Given the administrative and cost burden of the new tax law, criticism has emerged worldwide from financial associations and governments since the FATCA was adopted on 18 March, 2010.

The EU sent a letter to US Treasury Secretary Timothy Geithner and Internal Revenue Commissioner Douglas Shulman warning of the negative effects of FATCA for Europe’s financial Industry.

However, Cayman’s financial services industry should not expect much help from the EU, which instead of rejecting the FATCA requirements as too onerous seeks to align them with its existing reporting systems under the European Savings Tax Directive.

EU tax commissioner Algirdas Semeta, who together with Hungarian Finance Minister Gyorgy Matolcsy, the chair of the EU’s Economic and Financial Affairs Council, signed the letter, said in April: “This initiative puts costly obligations on financial institutions. We have engaged in a dialogue with the US Treasury to seek more proportionate conditions for the EU financial industry, building on the synergies between FATCA and the EU Savings Directive.”

Rather than obliging European financial institutions to develop new systems and mechanisms, the EU proposes to use already existing tools to exchange tax information between tax authorities in Europe such as the EU’s Savings Tax Directive and the Directive on Administrative Cooperation. Given that the EU has aimed to extend the scope of the Savings Tax Directive and that it has similar goals as FATCA, the EU has invited the US to consider whether it can be used to obtain the desired information and at the same time save costs.

“The presidency and the Commission discussed the issue with EU member states and obtained their support for an EU-wide approach aimed at exploring solutions that would ensure that US tax authorities can obtain the information they require on investments by US residents in foreign financial institutions without any excessive burden on the EU financial industry,” the EU said in a statement.



  1. Is the US going to afford the FDIC insurance of 250,000 per account to its nationals living in the affected countries utilizing the affected financial institutions seeing as how they expect everything else?

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