FATCA and the feedback loop

In the United States, domestic financial institutions provide financial statements to the account holder and to the U.S. tax authorities: The Internal Revenue Service. This allows the IRS to ensure that all income is fully disclosed. For offshore accounts, historically foreign financial institutions (FFI) have only provided information about financial accounts to the individual. The individual is expected to voluntarily report income information to the IRS on their tax forms through a FBAR or 8938 Report.

The Foreign Account Tax Compliance Act (FATCA) was created to bridge that gap. By getting foreign financial institutions to report information about U.S. taxpayers with offshore financial accounts, the IRS can compare that information with individuals’ annual tax forms and determine if they have any undeclared offshore income.

What many foreign financial institutions do not realize is that this can work both ways. Let us take a hypothetical foreign financial institution that has signed up for FATCA and agreed to report U.S. taxpayer information. If they fail to file a FATCA report, one of two things can be true: the FFI has no U.S. taxpayers or the FFI has U.S. taxpayers and simply did not fulfil its obligations to report. Let us say the FFI has 10 U.S. accounts that should have been reported. If even one of the 10 U.S. taxpayers voluntarily reports their FFI offshore account, the IRS knows the FFI is not fulfilling its obligations. In reverse, if the FFI reports all 10 of the U.S. taxpayers and only one volunteers that information, the IRS can go after the other nine for failing to report.

This introduces a bit of game theory called the “prisoner’s dilemma.” In the prisoner’s dilemma, a policeman catches two suspects at the scene of crime. The policeman arrests them and puts them in separate cells so they cannot communicate. He tells each of them that he has no physical evidence, so if both claim they are innocent, he will be forced to set them free. If either prisoner admits the two suspects did the crime, the policeman will ask the judge to provide a very light sentence to reward their honesty. However, if one prisoner admits guilt and the other claims innocent, the policeman will ask the judge for the maximum penalty to the liar who claimed he was innocent.

In theory, it would be in the best interest of both prisoners to claim innocence and get released. However, since each prisoner does not know what the other will do, more often than not, rational people will admit guilt and take a light sentence, afraid if they claim innocence, the other might admit guilt and they will get a long prison sentence. This is true of the FFI and U.S. taxpayers. It would be in both parties’ best interest to not report the income, however, afraid the other party might, both parties are likely to comply.

Currently, the IRS is running an amnesty program for U.S. taxpayers. If a taxpayer comes forth and declares previously undeclared offshore accounts, they have to pay the back taxes, interest, and a 20 percent penalty, and then are forgiven. This is better than if the IRS finds the taxpayer first.

If I were the IRS, I would take the next 100 people that ask for amnesty and list the financial products and the foreign financial institutions that hold those products. I would then pull the FATCA forms for each of these financial institutions. Behind every account there was a sales person. This sales person was likely targeting U.S. clients, and somehow, at least one U.S. client got the idea that in the years before FATCA they could maintain the account and likely get away without paying taxes. For each FATCA form, one of two things would happen: There is no FATCA filing, in which case the IRS could hold the FFI to account by formally notifying the FFI or jurisdiction of their failure to adhere to their reporting commitments; or a FATCA form is filed. With the FATCA form, I would pull the tax returns of everyone on the form, looking for individuals that did not voluntarily declare the offshore income.

Like the traffic police, they do not have the manpower to catch everyone. The goal is to get voluntary compliance. Catch enough people that it scares the rest into complying. In addition, although matching declared accounts with those reported on FATCA forms would be a straightforward IT exercise, I would advise against it on the grounds that it would tip the IRS’s hand. If you attempt to match all the accounts, if someone does not receive a letter of non-compliance, the IRS would inadvertently be sending the message that you are “in the clear” and have gotten away with not reporting.

Unlike anti-money laundering, where the chances of being caught with a sanctioned individual or entity in your client base was relatively remote and AML compliance was really determined by the local regulators, with FATCA the IRS has the data to show compliance or the lack thereof. In addition, there are real dollars behind this. Every tax cheat caught means more dollars for a depleted U.S. Treasury. Be forewarned.

David Olenzak is the founder and president of Trans World Compliance, Inc., a provider of the FATCA One line of compliance software for financial institutions and tax authorities to support U.S. FATCA, U.K. FATCA, and Common Reporting Standard regulations. Olenzak is a serial entrepreneur with a background in IT and spent 15 years in compliance and RegTech.