Preparing for the dawn of FATCA

While it is not yet certain what the Foreign Account Tax Compliance Act will look like in its final form, the inevitability of FATCA being implemented is clear, tax professionals said. Accordingly, Cayman financial institutions and to a comparatively lesser extent, individuals, should be preparing in anticipation of the mid-2013 registration deadline. 

In March 2010, the United States enacted FATCA as an attempt to capture revenue from US entities the US government suspects are evading tax laws by keeping assets in foreign financial institutions and not reporting them properly. Tax professionals stressed that FATCA does not create new taxes; rather, FATCA is a measure to enforce existing tax laws. 

“That’s a bit of a misconception I hear in the marketplace,” said Doug Harrell, who is a partner with KPMG and head of the firm’s US tax practice in the Cayman Islands. “In most instances, the tax laws haven’t changed. Most of them have been in place for quite a while.” 

FATCA is novel in that it compels foreign institutions – including banks, brokerages, investment funds, insurance companies, trusts, etc. – to enter into an agreement with the Internal Revenue Service to report information on US account holders and investors, under threat of a 30 per cent withholding tax on US-sourced income. 

“I think that FATCA is here to stay. Nothing from Treasury or the IRS suggests that it might be shelved and at this point it would take an act of Congress to undo it. Foreign Financial Institutions should be taking the necessary steps to be compliant for when it comes into effect,” said Chris Larkin, senior manager, Ernst & Young Ltd., Cayman Islands. 

Following the 30 June, 2013, deadline for foreign financial institutions to enter into an agreement with the IRS, other FATCA provisions, such as withholdings, will be implemented in phases through 2015, according to the most recent guidance released by the IRS in July. The original statute called for an effective date of January 2013. Larkin said there is no reason at this time to believe the IRS will push back the deadlines any further. 

Harrell said FATCA will give the US government new abilities to track down and identify individuals skirting tax laws. “The US has always felt that Americans should be paying taxes on worldwide income,” he said. 

FATCA and individuals 

US Sen. Carl Levin, a vocal critic of offshore tax havens, has said abuse of tax havens and offshore accounts results in annual losses of more than $100 billion to the US government. Describing that figure as “mindboggling”, Harrell said, “I have no idea how they came up with this number. I don’t know anyone who knows where they came up with this number”. 

FATCA itself is intended to raise $7.67 billion in net revenue over 10 years. 

The US government has always required that US citizens and permanent residents file tax returns and pay federal taxes, regardless of what country they are living in. In the past, many US citizens and residents have – likely often due to ignorance, rather than intention – neglected to file the appropriate paperwork, especially if they had little or no tax liability due to, for example, qualifying for foreign earned income exclusion.  

“Now the US government has made it very clear that if you’re a US citizen or green card holder, or otherwise required to file a tax return, that you are expected to do that even if you have no tax liability,” said Asher Harris, a US tax attorney specialising in international tax. 

For most US individuals who have been filing IRS statements regularly and paying taxes properly, the implementation of FATCA should have little practical impact – beyond providing proof of US status, in the form of a passport or birth certificate, for example, when financial institutions request it. 

“From an individual perspective, if you’ve been compliant annually with all the IRS reporting requirements – income tax, foreign income/account reporting requirements, and information reporting requirements – you should continue to do so. FATCA’s effect on individuals is that it will require foreign institutions to substantiate their account holder status as US or non-US, and they will need to certify that status with them via the forms and documentation required by FATCA. US status account holders and their specified data will then be reported annually on the FFI’s agreement that is filed,” Larkin said. 


“Collateral damage” of increased disclosure 

However, Patrick Hackenberg, a CPA with Capital Accountants, warned that some Caymanian residents with US status will suffer significantly from “collateral damage” caused by FATCA’s implementation. Specifically, when some local institutions investigate into the US or non-US status of customers, they will discover US individuals who own securities that are not registered with the US Securities and Exchange Commission, and may be compelled to close those accounts. For example, he said Cayman National Bank and Butterfield offer mutual funds that are not registered with US authorities due to compliance costs, and so are offered only to non-US persons. Previously, the institutions may not have asked Caymanians if they also held US status. 

“Through the FATCA due diligence process, they are going to find out that more of those persons are US persons than they realised. They are going to have to cancel those accounts for securities that are offered only to non-US persons,” said Hackenberg, who specialises in international tax reporting. 

For US individuals who have not been properly reporting income and assets to the IRS, the implementation of FATCA will pose serious obstacles for those still wishing to conceal assets in foreign institutions, specifically if the information provided to the IRS by the foreign institutions does not conform with information reported to the IRS by those individuals. 

“The scope of disclosure requirements is broadening. That comes into play for most people who file next April. The expectation is there is going to be a lot more disclosure than in the past,” Harris said. 

According to the IRS, FATCA requires certain US taxpayers holding foreign financial assets with an aggregate value exceeding US$50,000 to report information about those assets on a new two-page form (Form 8938), called a “Statement of Specified Foreign Financial Assets”, to be attached to the taxpayer’s annual tax reform. Reporting applies for assets held beginning after March 18, 2010. Failure to report those assets will result in a penalty of US$10,000, and a penalty of US$50,000 for continued failure after IRS notification. FATCA also increases the penalty for substantial understatement of income tax, attributable to non-disclosed foreign assets, from 20 per cent of the underpayment to 40 per cent. For an individual, an understatement is deemed “substantial” if the correct tax exceeds the understatement by more than 10 per cent, or US$5,000, whichever is greater. 

Hackenberg questioned the fairness of the new disclosure requirements. “When you live in the US, you don’t have to report your bank account balances, your brokerage accounts, anything like that. It’s very odd that just because you live offshore, now you have to report all of your foreign financial assets,” he said. 

“If you are a US citizen, it’s going to be increasingly difficult to move to a place (whether it’s the Cayman Islands or elsewhere) and not file your returns and not pay your taxes,” Harris said. 

“The goal of the law is to find people who are evading taxes, but if you’ve always reported your income, the result of the law is that it costs more to hire a tax preparer to fill out this form for you,” Hackenberg said. “So it makes it more costly to live offshore.” 

The message from the US government is that information derived from FATCA will only be used to identify irregularities in current tax statements, rather than going back in time to catch past offenders, Harrell said. 

“My understanding is it’s only going forward,” he said. “But we don’t have the final regulations yet. There are a lot of things dealing with FATCA that are in flux, are not sorted out yet.” 

Hackenberg said some institutions may simply decide not to enter into a FATCA agreement and will instead choose to sever relationships with US customers, which is already happening in Switzerland. Although, he did say that is unlikely to occur in Cayman because of local institutions’ integral relationship with the US. On an international level, US companies might have a harder time sending US individuals overseas because they might not be able to find appropriate banking relationships in those countries. 

Some dual nationals in Cayman may choose to drop their US status rather than subject themselves to FATCA scrutiny, he said. “I’ve heard people considering this more often. If the person doesn’t have a substantial net worth, generally under $2 million, it may be a practical way to stop the hassle of having the US government on their back,” Hackenberg said. “But then it becomes an emotional issue to have one renounce their US citizenship.” 


FATCA and institutions 

Leaders of foreign institutions argue that FATCA compliance will prove onerous and expensive. Harrell concurred with those sentiments. “Obviously financial institutions will be severely impacted by the cost of implementing systems to implement FATCA,” he said. 

Recently, the British Bankers’ Association sent a letter to the IRS and US Department of the Treasury, protesting against a FATCA provision requiring foreign institutions to levy the 30 per cent withholding tax on US-earned income payments to foreign institutions not participating in FACTA. The association expressed concerns about the ability of participating institutions to identify non-participating institutions, and warned that imposing with holding on the non-participating institutions could drive the non-participating institutions into distress, potentially causing systemic risk. 

Tax professionals cautioned that the actual impact of FACTA remains to be seen, depending on final guidelines the IRS has yet to produce but which possibly may appear this fall. Still, their advice to financial institutions is to prepare now rather than waiting for the final IRS guidelines. 

“If they’re not already thinking about FATCA implementation, they may be behind the eight ball,” Larkin said. 

In Cayman, which already feels scrutiny from US authorities, most financial institutions exercise circumspection to avoid assisting in the transgression of US tax law, Harris said. 

“In general, the Cayman financial institutions have been very cautious in terms of dealing with US persons with assets there, as they prepare for FATCA implementation,” he said. “Generally there has been a crackdown on the assets of non-Caymanians held in Cayman financial institutions. The expectation will be that that should certainly continue, and become more rigorous.” 

Larkin said some institutions in Cayman and throughout the world have been deliberate in their response to the advent of FATCA. 

“In regard to addressing FATCA, what we are seeing in some instances, whether in Cayman or globally, is a wait-and-see approach from FFIs. However, given the potential work involved it is advised to take action sooner rather than later,” he said. 

“What many foreign institutions will address up front are their data systems where the investor/account holder information is maintained. This could be both electronic and paper file data depending on the type of account. Assessing where the gaps are between existing client data and what FATCA will require is key to mapping out the approach for each FFI in becoming FATCA compliant. I suspect we will see some entities and some institutions developing software to assist with this process both internally and externally,” Larkin said.  

“From a hedge fund perspective, we’ll likely see the administrators for those funds, whether locally based or globally, utilising software solutions to assist with FATCA compliance or possibly updating (revamping) their current systems to capture the FATCA required information on investors and account holders,” he said. 

Larkin said FATCA can be viewed as an opportunity for many foreign financial institutions. “Those FFI’s whose systems and processes ensure FATCA compliance will, in most cases, be the preferred options for potential investors/clients going forward,” he said. 

The entities that will feel FATCA’s effects most are noncompliant US individuals, the US government itself and foreign institutions, Harrell said. 

“People not complying will either find some other way to hold their money or will have to change the amount of taxable income they have to report. Of course the US government is hoping for a big impact. They’re hoping to collect additional taxes,” he said. “On the front end, the most-impacted group is the foreign financial institutions, who will have to develop systems to comply with FATCA.” 

Hackenberg said, “It’s going to be primarily an additional cost to both companies and individuals to comply with the reporting, and it’s not going to produce the equivalent amount of tax revenue that the US is seeking.” 

He said, “My belief is there is more tax evasion within Delaware companies and Nevada companies than in all the offshore world.”